Black Knights Manufacturing is a national manufacturer of specialty sensors. The

Question

Black Knights Manufacturing is a national manufacturer of specialty sensors. The Shreveport, Louisiana plant will shut down on December 31, 2017. Audie Murphy, the Corporate Controller, has been asked by Jack Pershing, Chief Financial Officer, to look at three different options for the plant: Option 1: The plant, which has been fully depreciated for tax purposes, can be sold immediately for $425,000. Option 2: The plant can be leased to Midshipmen Manufacturing, (one of Black Knights suppliers), for four years. Under the terms of the lease, Midshipmen would make 4 annual lease payments of $125,000 (payable at year end) and Midshipmen would grant Black Knights a $25,000 annual discount off the normal price of circuit boards purchased by Black Knights. Under the rental agreement, Midshipmen would bear all of the plant's ownership costs. Black Knights expects to be able to sell the plant for $70,000 at the end of the four-year lease. Option 3: The plant could be used for four years to make specialty door sensors for General Motors. Fixed manufacturing overhcad costs before equipment upgrades are estimated to be S12,500 annually for the four year-period. The sensors are expected to sell for $70 each. Variable cost per unit is expected to be $57. The following production AND sales of sensors are expected to be: 2018 8,000 units; 2019 15,000 units; 2020 17,000 units; 2021 4,000 unit To facilitate production of the specialty sensors, some of the plant's equipment immediately upgraded at a cost of $88,000. The upgraded equipment has no salvag would need to be ill be depreciated under the straight-line method over the four years it would be in use. Because of the upgrades, Black Knights could sell the plant for $150,000 at the end of the four years. Black Knights treat all cash flows as if they occur at the end of the year. The company uses an after tax required rate of return of 12%. Black Knights is subject to a 34% tax rate on all income Ca lculate net present value of each of the options and determine which option Black Knights should select. What nonfinancial factors should Black Knights consider before making its decision?

Explanation / Answer

Option 1 Sell at 425000 Option 2 Year Lease Benefit Benefit Tax Post tax benefit Residual FCF Disc Fact. 1 125000 25000 150000 51000 99000 99000 0.8928571            88,393 2 125000 25000 150000 51000 99000 99000 0.7971939            78,922 3 125000 25000 150000 51000 99000 99000 0.7117802            70,466 4 125000 25000 150000 51000 99000 99000 0.6355181            62,916 4 70000 70000 0.6355181            44,486 PV of the Benfits        3,45,184 Option3 Capital Flow Cont p/u Units sold Fixed Cost PBD Depn EBT Tax PAT OCF FCF Disc rate PV 0        -88,000          -88,000    1.00000          -88,000 1               13           8,000        12,500            91,500        22,000            69,500        23,630            45,870            67,870            67,870    0.89286            60,598 2               13        15,000        12,500        1,82,500        22,000        1,60,500        54,570        1,05,930        1,27,930        1,27,930    0.79719        1,01,985 3               13        17,000        12,500        2,08,500        22,000        1,86,500        63,410        1,23,090        1,45,090        1,45,090    0.71178        1,03,272 4               13           4,000        12,500            39,500        22,000            17,500           5,950            11,550            33,550            33,550    0.63552            21,322 NPV        1,99,177 Option 3 is better, at it has highest NPV

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