This exercise parallels the machine-purchase decision for the Mendoza Company th
ID: 2575881 • Letter: T
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 $5,100,000 and cash expenses of $3,750,000, one-third of which are labor costs. The current level of investment in this existing division is $12,550,000. (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 $41,500 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 $454,000 per year. Raw materials costs associated with the new line are expected to be $1,510,000 per year, while the total labor cost is expected to double.
The CFO of the company estimates that new machinery costing $4,200,000 would need to be purchased. This machinery has a eight-year useful life and an estimated salvage (terminal) value of $672,000. 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 9% (after-tax) and that the combined (federal and state) income tax rate is 27%. Finally, assume that the new business line is expected to generate annual cash revenue of $4,350,000.
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.
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 $5,100,000 and cash expenses of $3,750,000, one-third of which are labor costs. The current level of investment in this existing division is $12,550,000. (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 $41,500 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 $454,000 per year. Raw materials costs associated with the new line are expected to be $1,510,000 per year, while the total labor cost is expected to double.
The CFO of the company estimates that new machinery costing $4,200,000 would need to be purchased. This machinery has a eight-year useful life and an estimated salvage (terminal) value of $672,000. 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 9% (after-tax) and that the combined (federal and state) income tax rate is 27%. Finally, assume that the new business line is expected to generate annual cash revenue of $4,350,000.
Explanation / Answer
Answer:
Step 1: formulas and basic calculation used
Depreciation :Machine value/ life of the machine = 4200000/8 = 525000
Present value formula : cash flow after tax/( 1 + interest rate ) ^ (no of years)
Labor cost has doubled and it was initially one third of 3750000
So, added labor cost = 1/3 * 3750000 = 1250000
Step 2: Before the starting year 0 is the project initiation from 1-7 is project operation stage and 8 is the project disposal stage
Project is Executable as it has positive NPV which is the sum of all the present value of cash flows
Step 3:
Project intiation stage cash flow : -$4241500
Project operation stage cash flow : $4887148.1
Project disposal : $748726.77
New Business Line Project Intiation project operation Project Disposal 0 1 2 3 4 5 6 7 8 Net Working Capital -41500 41500 Additional cash expenses -454000 -454000 -454000 -454000 -454000 -454000 -454000 -454000 Raw Material cost -1510000 -1510000 -1510000 -1510000 -1510000 -1510000 -1510000 -1510000 Labor cost -1250000 -1250000 -1250000 -1250000 -1250000 -1250000 -1250000 -1250000 Machinery cost -4200000 Salvage value 0 0 0 0 0 0 0 672000 Annual cash revenue 4350000 4350000 4350000 4350000 4350000 4350000 4350000 4350000 net Cash flow -4241500 1136000 1136000 1136000 1136000 1136000 1136000 1136000 1849500 Depreciation 525000 525000 525000 525000 525000 525000 525000 525000 Cash flow for tax -4241500 611000 611000 611000 611000 611000 611000 611000 1324500 Tax (27%) 0 164970 164970 164970 164970 164970 164970 164970 357615 Cash flow after tax -4241500 971030 971030 971030 971030 971030 971030 971030 1491885 Present value of cash flow -4241500 890853.2 817296.5 749813.3 687902.1 631102.9 578993.5 531186.7 748726.7746 NPV value 1394375Related Questions
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