J. Smythe, Inc., manufactures fine furniture. The company is deciding whether to
ID: 2773371 • Letter: J
Question
J. Smythe, Inc., manufactures fine furniture. The company is deciding whether to introduce a new mahogany dining room table set. The set will sell for $8,000, including a set of eight chairs. The company feels that sales will be 2,450, 2,600, 3,150, 3,000, and 2,750 sets per year for the next five years, respectively. Variable costs will amount to 47 percent of sales, and fixed costs are $1.98 million per year. The new dining room table sets will require inventory amounting to 8 percent of sales, produced and stockpiled in the year prior to sales. It is believed that the addition of the new table will cause a loss of sales of 650 dining room table sets per year of the oak tables the company produces. These tables sell for $5,300 and have variable costs of 42 percent of sales. The inventory for this oak table is also 8 percent of sales. J. Smythe currently has excess production capacity. If the company buys the necessary equipment today, it will cost $15 million. However, the excess production capacity means the company can produce the new table without buying the new equipment. The company controller has said that the current excess capacity will end in two years with current production. This means that if the company uses the current excess capacity for the new table, it will be forced to spend the $15 million in two years to accommodate the increased sales of its current products. In five years, the new equipment will have a market value of $3.9 million if purchased today, and $6.1 million if purchased in two years. The equipment is depreciated on a seven-year MACRS schedule. The company has a tax rate of 40 percent, and the required return for the project is 13 percent.
The table below shows the 7 year MACRS schedule
Table 8.3 MARCS Schedule
J. Smythe, Inc., manufactures fine furniture. The company is deciding whether to introduce a new mahogany dining room table set. The set will sell for $8,000, including a set of eight chairs. The company feels that sales will be 2,450, 2,600, 3,150, 3,000, and 2,750 sets per year for the next five years, respectively. Variable costs will amount to 47 percent of sales, and fixed costs are $1.98 million per year. The new dining room table sets will require inventory amounting to 8 percent of sales, produced and stockpiled in the year prior to sales. It is believed that the addition of the new table will cause a loss of sales of 650 dining room table sets per year of the oak tables the company produces. These tables sell for $5,300 and have variable costs of 42 percent of sales. The inventory for this oak table is also 8 percent of sales. J. Smythe currently has excess production capacity. If the company buys the necessary equipment today, it will cost $15 million. However, the excess production capacity means the company can produce the new table without buying the new equipment. The company controller has said that the current excess capacity will end in two years with current production. This means that if the company uses the current excess capacity for the new table, it will be forced to spend the $15 million in two years to accommodate the increased sales of its current products. In five years, the new equipment will have a market value of $3.9 million if purchased today, and $6.1 million if purchased in two years. The equipment is depreciated on a seven-year MACRS schedule. The company has a tax rate of 40 percent, and the required return for the project is 13 percent.
The table below shows the 7 year MACRS schedule
Explanation / Answer
NPV of purchasing machinery now -$ $ 2,484,876.47
NPV of using excess capacity and purchasing machinery after two years $ 6,177,718.16
Hence it is better to use the excess capacity to produce the new dining set now and purchase the machinery after two years.
Working
Scenario I
Cash Flows Associated with purchase of machinery immediately
Year 0
Year 1
Year 2
Year 3
Year 4
Year 5
Cost of Machine
-15000000
inc in inventory
-1292400
-1388400
-1740400
-1644400
-1484400
Net Cash inflows
3845940
4227540
5626740
5245140
4609140
Salvage Value = 3,900,000
Required Return c = 13%
NPV = -15,000,000 – 1,292,400 +3,845,940/1.13 – 1,388,400/1.13 + 4,227,540/1.13^2 – 1,740,400/1.13^2 +5,626,740/1.13^3 – 1,644,400/1.13^3 + 5,245,140/1.13^4 – 1,484,400/1.13^4 + 4,609,140/1.13^5 + 3,900,000/1.13^5
Using the discounting factors (1/(1+c)^n) from workings below
NPV = -15,000,000 – 1,292,400 +3,845,940 * 0.8850 – 1,388,400* 0.8850 + 4,227,540 * 0.7831 – 1,740,400* 0.7831 +5,626,740*0.6931 – 1,644,400*0.6931 + 5,245,140*0.6133 – 1,484,400*0.6133 + 4,609,140*0.5428 + 3,900,000*0.5428
NPV = -15,000,000 – 1,292,400+3403486.73-1228672.57+3310783.93-1362988.49+3899613.07-1139651.69+3216942.59-910410.32+2501656.53+2116763.75
NPV = - $ 2,484,876.47
Scenario II
Using excess capacity for 2 years and purchase machinery use the same for 3 years
Year 0
Year 1
Year 2
Year 3
Year 4
Year 5
Cost of Machine
-15000000
inc in inventory
-1292400
-1388400
-1740400
-1644400
-1484400
Net Cash inflows
5132040
6431640
5626740
5245140
4609140
Salvage Value = $ 6,100,000
Required rate of return c = 13%
NPV = – 1,292,400 +5,132,040 * 0.8850 – 1,388,400* 0.8850 + 6,431,640 * 0.7831 – 1,740,400* 0.7831 - -15,000,000 *0.7831 +5,626,740*0.6931 – 1,644,400*0.6931 + 5,245,140*0.6133 – 1,484,400*0.6133 + 4,609,140*0.5428 + 6,100,000*0.5428
NPV = -1,292,400 +4541628.32+5036917.53-1228672.57+3899613.07-1362988.49-10395752.40+3216942.59-1139651.69+2501656.53-910410.32+3310835.61
NPV = $ 6,177,718.16
Cash Flows in Scenario I
Year 0
Year 1
Year 2
Year 3
Year 4
Year 5
Expected sales in Units
2450
2600
3150
3000
2750
Price of each dining set
8000
8000
8000
8000
8000
Sales Value of New Dining Set
19600000
20800000
25200000
24000000
22000000
Variable Costs @ 47% of sales
9212000
9776000
11844000
11280000
10340000
Fixed Costs
1980000
1980000
1980000
1980000
1980000
Loss of contribution from Oak Sets
1998100
1998100
1998100
1998100
1998100
Depreciation (MARCS Value)
2143500
3673500
2623500
1873500
1339500
PBT
4266400
3372400
6754400
6868400
6342400
Tax @ 40%
1706560
1348960
2701760
2747360
2536960
PAT
2559840
2023440
4052640
4121040
3805440
Net Cash Flow (PAT + Depn (1-Tax)
3845940
4227540
5626740
5245140
4609140
Loss on Sale of Oak Sets due to introduction of new dining sets
No of Units
650
650
650
650
650
Sale Price
5300
5300
5300
5300
5300
Total Sales
3445000
3445000
3445000
3445000
3445000
Variable costs @ 42% of sales
1446900
1446900
1446900
1446900
1446900
Cash Flows in Scenario II
Year 0
Year 1
Year 2
Year 3
Year 4
Year 5
Expected sales in Units
2450
2600
3150
3000
2750
Price of each dining set
8000
8000
8000
8000
8000
Sales Value of New Dining Set
19600000
20800000
25200000
24000000
22000000
Variable Costs @ 47% of sales
9212000
9776000
11844000
11280000
10340000
Fixed Costs
1980000
1980000
1980000
1980000
1980000
Loss of contribution from Oak Sets
1998100
1998100
1998100
1998100
1998100
Depreciation (MARCS Value)
0
0
2143500
3673500
2623500
PBT
6409900
7045900
7234400
5068400
5058400
Tax @ 40%
2563960
2818360
2893760
2027360
2023360
PAT
3845940
4227540
4340640
3041040
3035040
Net Cash Flow (PAT + Depn (1-Tax)
5132040
6431640
5626740
5245140
4609140
Depreciation
Cost of New Machinery
15000000
MACRS Depreciation rate (%)
14.29
24.49
17.49
12.49
8.93
Depreciation
2143500
3673500
2623500
1873500
1339500
Net Change in Inventory
Year 0
Year 1
Year 2
Year 3
Year 4
Increase in inventory of new set
1568000
1664000
2016000
1920000
1760000
Decrease in inventory of Oak Set
275600
275600
275600
275600
275600
Net Change in Inventory
1292400
1388400
1740400
1644400
1484400
Discounting Factor
(1+c)n for c = 13% and n = 5 years
1.1300
1.2769
1.4429
1.6305
1.8424
1/(1+c)^
0.8850
0.7831
0.6931
0.6133
0.5428
Year 0
Year 1
Year 2
Year 3
Year 4
Year 5
Cost of Machine
-15000000
inc in inventory
-1292400
-1388400
-1740400
-1644400
-1484400
Net Cash inflows
3845940
4227540
5626740
5245140
4609140
Related Questions
Navigate
Integrity-first tutoring: explanations and feedback only — we do not complete graded work. Learn more.