Question
In: Accounting
You are considering the following capital investment. You can buy a shoelace manufacturing machine for 7...
You are considering the following capital investment. You can buy a shoelace manufacturing machine for 7 million dollars. The machine would be depreciated using straight-line depreciation over 7 years. Assume first that the revenue from shoelace sales would be 3.2 million dollars per year, and variable costs would be 2 million per year. Assuming your firm has a beta of 1.2 and is all equity financed, and that the expected return on the market is 8% that the risk-free rate is 1%, and your firm has a marginal tax rate of 21%, is this a good investment?
1.b) How much is the option to sell the machine after 5 years for 3 million dollars (and exit the business) worth to you
1,c) If you can sell shoelaces at $2 and have variable costs of $0.50, how many shoelaces do you need to sell to have an accounting breakeven?
1.d) How many do you need to sell to have positive EVA/NPV?
Solutions
Expert Solution
| 1) | ($ millions) | ||||||||
| Year | Cash inflow | Cash outflow | Net Cashflow | Depreciation | Net profit | Tax @21% | Cashflow after tax | PVF @ 9.40 % | Discounted Value |
| (a) | (b) | (c ) | (d=b-c) | (e ) | (f=d-e) | (g=f x 21%) | (h=d-g) | (i) | (J=h x i) |
| - | - | 7.00 | -7.00 | - | -7.00 | - | -7.00 | 1.00 | -7.00 |
| 1 | 1.20 | - | 1.20 | 1.00 | 0.20 | 0.04 | 1.16 | 0.91 | 1.06 |
| 2 | 1.20 | - | 1.20 | 1.00 | 0.20 | 0.04 | 1.16 | 0.84 | 0.97 |
| 3 | 1.20 | - | 1.20 | 1.00 | 0.20 | 0.04 | 1.16 | 0.76 | 0.88 |
| 4 | 1.20 | - | 1.20 | 1.00 | 0.20 | 0.04 | 1.16 | 0.70 | 0.81 |
| 5 | 1.20 | - | 1.20 | 1.00 | 0.20 | 0.04 | 1.16 | 0.64 | 0.74 |
| 6 | 1.20 | - | 1.20 | 1.00 | 0.20 | 0.04 | 1.16 | 0.58 | 0.68 |
| 7 | 1.20 | - | 1.20 | 1.00 | 0.20 | 0.04 | 1.16 | 0.53 | 0.62 |
| Net Present Value | -1.25 | ||||||||
| It is not recommend to invest in this project as having negative Net Present Value. So it is not a good investment. | |||||||||
| Working Notes: | |||||||||
| (i)Net cash inflow: | ($ millions) | ||||||||
| (1) | Sales | Variable cost | Net Cash Inflow | ||||||
| 1-7 year | 3.20 | 2.00 | 1.20 | ||||||
| (ii) Annual Depreciation = $ 7 million/7 = $ 1 million | |||||||||
| (iii) Cost of capital = Risk free rate + Beta (Market rate - Risk free rate) | |||||||||
| Cost of capital = 1% + 1.2 (8% -1%) | |||||||||
| Cost of capital = 9.4 % | |||||||||
| 1b) Present worth for $ 3 million of machine shall be recover after 5 year is ($ 3 million x .64) = $ 1.92 millions | |||||||||
| 1c) Contribution = Sales - Variable cost | |||||||||
| Contribution = $ 2 - $ .50 = $ 1.50 per shoelaces | |||||||||
| Breakeven Sales in unit = Fixed cost / Contribution per unit | |||||||||
| Breakeven Sales in unit = $ 7 millions / $ 1.50 per shoelaces | |||||||||
| Breakeven Sales in unit = $ 46,66,667 shoelaces | |||||||||
| 1d) EVA = Net operating profit after tax - (Invested Capital x Cost of capital) | |||||||||
| then Net operating profit after should be more that ($ 7 million x 9.4%) = $ 6,58,000 |
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