Rob Roy Corporation has been using its present facilities at its annual full cap

Question

Rob Roy Corporation has been using its present facilities at its annual full capacity of 10.000 units for the last 3 years. Still company is unable to keep pace with continuing demand for the product that is estimated to be 25,000 units annually This demand level is expected to continue for at least another 4 years. To expand manufacturing capacity and take advantage of the demand, Rob Roy must acquire equipment costing $1.000,000. The equipment will double the current production quantity. This equipment has a useful life of 10 years and can be sold for $200.000 at the end of year 4 or $30.000 at the end of year 10. Analysis of current operating data provides the following information: $232 Sales price Variable costs: Manufacturing Marketing s 97 1er $187 Fixed costs: s 45 Manufacturing Other 25 7e Pretax operating income s 55 The fixed costs include depreciation expense of the current equipment. The new equipment will not change variable costs, but the firm will incur additional fixed manufacturing costs (excluding depreciation on the new machine) of $250.000 annualy. The firm needs to spend an additional $200.000 in fixed marketing costs per year for additional sales Rob Roy is in the 35% tax bracket Management has set a minimum rate of return of 15.0% after-tax for all capitai investments. Assume, for simplicity, that MACRS depreciation rules do not apply

Explanation / Answer

Workings: Incl.units 10000 Selling Price /unit 232 Less: Varaiable costs /unit 107 Total contribution (232-107)*10000= 1250000 Less: Incremental mfg.Fcs 250000 Incremental mkg.costs 200000 Depn of new equipment(1000000-200000)/4 200000 Incremental BT income 600000 Less:Tax at 35% 210000 1..Incremenatl AT opg.income 390000 Add back :depn. 200000 2..After Tax Cash Flows 590000 1. Effect of the new equipment on operating income after tax 390000 Increase 2. Effect of the new equipment on after-tax cash inflows in each of the 1st 3 years 590000 Increase Effect of the new equipment on after-tax cash inflows in the 4th year 590000 After-tax salvage 200000 incl.after-tax cash inflows in the 4th year 790000 Increase 4.Payback period 1000000/590000= 1.69 years Accounting rate of return= Av. Net profit/ Initial Investment 390000/1000000= 39% Based on Av.investment 390000/250000= 156% 5.NPV of the investment Initial Investment -1000000 PV of 4 yr.ATCFs 590000*2.85498= 1684438 PVOA,F. 15%.4 yrs. PV of after-tax salvage 200000*0.57175= 114350 PV ,F. 15%. Yr.4 NPV of the investment 798788 6..IRR Cash flows Year 0 -1000000 1 590000 2 590000 3 590000 4 790000 IRR= 49% 7..MIRR= 33% 8.a.To justify the investment NPV generated , if not +ve, must atleast be 0 NPV =0 at IRR or cost of capital= 15% (min. reqd. rate of return) From the previous NPV calculations, in 5. above,   for NPV to be 0 Total PV of   4 yr.ATCFs should be -1000000+114350= 885650 So,per year ATCF= x*2.85498=885650 x=885650/2.85498= 310212 Incremental ATCF 310212 Less: Depn. Added back -200000 Incremenatl AT opg.income 110212 Incremenatl BT opg.income110212/65*100= 169557 Add Back: all incl.fixed costs 650000 Total contribution for 10000 units 819557 Contribution /unit 82 Selling price/unit 232 So, variable cost /unit(232-82) 150 So, variable cost can increase by 150-107= 43 to JUSTIFY the PURCHASE. (NOTE: IRR has been taken as 15% & not 14% ) 8.b.To justify the investment NPV generated , if not +ve, must atleast be 0 NPV =0 at IRR or cost of capital= 15% (min. reqd. rate of return) From the previous NPV calculations, in 5. above,   for NPV to be 0 Total PV of   4 yr.ATCFs should be -1000000+114350= 885650 So,per year ATCF= x*2.85498=885650 x=885650/2.85498= 310212 Incremental ATCF 310212 Less: Depn. Added back -200000 Incremenatl AT opg.income 110212 Incremenatl BT opg.income110212/65*100= 169557 Add Back: all fixed costs(650000+700000) 1350000 Total contribution reqd. for 20000 units 1519557 Contribution reqd./unit 76 variable cost /unit 107 So.selling price/unit(76+107) 183 So, selling price/unit cost can decrease by 232-183= 49 to JUSTIFY this equipment PURCHASE. (NOTE: IRR has been taken as 15% & not 14% )

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