Kramerica Industires plans to introduce a new product to the market. Last week,
ID: 2797234 • Letter: K
Question
Kramerica Industires plans to introduce a new product to the market. Last week, Kramerica hired a marketing firm to develop a TV ad for the product. The marketing firm will develop the ad regardless of Kramerica's decision to continue the project or not. The project will require additional working capital of $300,000 which will be recovered at the condlusion of the project. The firn has spent $250,000 on R&D; for this project. To launch the project Kramerica will have to invest $26 million today in plant and machinery. The plant and machinery have an economic life of 20 years and a salvage value of $4 million. The project is expected to generate sales of $9 million per year for 20 years. Of these, 20% are due to lost sales of the existing products or the company. The incremental variable costs of producing the product is $3.4m. Fixed costs are $700,000 per year, Kramerica's accountants have allocated $400,000 in managerial salaries to the project but no additional managers need to be company uses straight line depreciation. It has a The cash flow in year 20 (t-20) is $ marginal tax rate of 40% and a 10% cost of capital. 6,700,0o0 O6,680,000 6,650,000 6,620,0o0 () 6,600,000Explanation / Answer
Marketing, R&D costs are sunk costs and will not be considered as part of analysis.
Plant and Equipment Cost =$26,000,000
Economic Life = 20 years
Salvage Value =$4,000,000
Annual Depreciation using Straight Line =$26,000,000/20 =$1,300,000
Income Statement
Sales $ 7,200,000 [Incremental Sales = 9,000,000x(1-0.20)=7,200,000]
Less Incremental Variable Cost $ - 3,400,000
Less Fixed Costs $ -700,000
Less Annual Depreciation $ -1,300,000
Annual EBIT $ 1,800,000
Annual Cash Flows = EBIT x (1-T) + D
=$ 1,800,000x(1-0.40) + 1,300,000
=$ 1,080,000 + 1,300,000
=$ 2,380,000
Cash Flows in Year-20 =$2,380,000 + 300,000 + 4,000,000 =$6,680,000
Hence, option-b is the correct answer
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