Watson\'s Bay Co. is considering a contract to manufacture didgeridoos. Producin

ID: 2381013 • Letter: W

Question

Watson's Bay Co. is considering a contract to manufacture didgeridoos. Producing didgeridoos will require an investment in equipment of $100,000 and operating costs of $15 per didgeridoo produced. The contract calls for the company to deliver 2,000 didgeridoos a year for each of 4 years at a price of $30 per didgeridoo. At the end of 4 years the equipment is expected to be sold for $10,000. The equipment will be depreciated as follows:

Year Depreciation Factor

1 0.3333

2 0.4445

3 0.1481

4 0.0741

The depreciation factor is applied to the full cost of the equipment (i.e., salvage value is not considered when depreciation is determined). The tax rate is 33%, and the market rate of return for investments of this risk is 20%. Should Watson's Bay Co. take the contract to manufacture didgeridoos?

Explanation / Answer

REVENUE EACH YEAR = (30-15)*2000 = 30000

YEAR

DEPRECIATION

CASHFLOWS=(REVENUE-DEP)(1-t) + DEP

P.V. 20%

-100000

100000*0.3333

=33330

(30000-33330)*0.67 + 33330

= 31099

31099/1.20 =25916

100000*0.4445

=44450

(30000-44450)*0.67 + 44450

=34769

34769/(1.2^2) =24145

100000*0.1481

=14810

(30000-14810)*0.67 + 14810

=24987

24987/(1.2^3) =14460

=100000*0.0741

=7410

(30000-7410)*0.67+ 7410 + POST TAX SALVAGE VALUE OF EQUIOMENT

=22545+6700

=29245

29245/(1.2^4) =14103

TOTAL

100000

NPV=

-21376

POST TAX SALVAGE VALUE OF EQUIOMENT = 10000*0.67 =6700

THE CONTRACT SHOULD NOT BE ACCEPTED