This exercise parallels the machine-purchase decision for the Mendoza Company th

Question

This exercise parallels the machine-purchase decision for the Mendoza Company that is discussed in the body of the chapter. Assume that Mendoza is exploring whether to enter a complementary line of business. The existing business line generates annual cash revenues of approximately $4,650,000 and cash expenses of $3,705,000, one-third of which are labor costs. The current level of investment in this existing division is $12,700,000. (Sales and costs of this division are not affected by the investment decision regarding the complementary line.)
  
Mendoza estimates that incremental (noncash) net working capital of $37,000 will be needed to support the new business line. No additional facilities-level costs would be needed to support the new line—there is currently sufficient excess capacity. However, the new line would require additional cash expenses (overhead costs) of $442,000 per year. Raw materials costs associated with the new line are expected to be $1,420,000 per year, while the total labor cost is expected to double.
  
The CFO of the company estimates that new machinery costing $3,900,000 would need to be purchased. This machinery has a six-year useful life and an estimated salvage (terminal) value of $624,000. For tax purposes, assume that the Mendoza Company would use the straight-line method (with estimated salvage value considered in the calculation).

Assume, further, that the weighted-average cost of capital (WACC) for Mendoza is 11% (after-tax) and that the combined (federal and state) income tax rate is 39%. Finally, assume that the new business line is expected to generate annual cash revenue of $4,125,000.

Required:
Determine relevant cash flows (after-tax) at each of the following three points: (1) project initiation, (2) project operation, and (3) project disposal (termination). For purposes of this last calculation, you can assume that the asset is sold at the end of its useful life for the salvage value used to establish the annual straight-line depreciation deductions; further, you can assume that at the end of the project’s life Mendoza will fully recover its initial investment in net working capital.

Explanation / Answer

Part 1)

The cash inflow at project initiation is calculated as below:

Cash Flow at Project Initiation = Cost of New Machinery + Investment in Working Capital = 3,900,000 + 37,000 = $3,937,000

_____

Part 2)

The value of cash flow during project operation is determined with the use of following table:

Cash Flow during Project Operation = $840,020

_____

Part 3)

The cash flow at project disposal (termination) is determined as below:

Cash Flow at Project Disposal (Termination) = Salvage Value + Recovery of Working Capital = 624,000 + 37,000 = $661,000

Incremental Cash Revenues 4,125,000 Incremental Cash Expenses Raw Materials 1,420,000 Labor (3,705,000/3) 1,235,000 Overhead 442,000 Total Incremental Expenses 3,097,000 Incremental Non-Cash Expenses Depreciation [(3,900,000 - 624,000)/6] 546,000 EBT 482,000 Less Taxes 187,980 EAT 294,020 Add Depreciation 546,000 Annual After-Tax Cash Inflow $840,020

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