In: Accounting
Your employer is considering a capital project that involves installing a new manufacturing line at a cost of $1,880,000. The line will be installed area of the factory that was refurbished in 2017. At that time, the refurbishment cost $950,000. If it is not employed by this project, that area of the factory will remain unused. The new manufacturing line, if built, will be depreciated on a straight-line basis over five years, to a salvage value of $0. If implemented, the project will cause an immediate increase in Inventory of $260,000. It will also cause immediate increases in Accounts Receivable of $290,000, Accounts Payable of $160,000, and Long-Term Debt of $1.2million.
If implemented, the project is expected to generate annual sales of $3,375,000 by the end of the first year. Sales are expected to increase 6% per year. COGS expense is expected to be of $1,599,600 during the first year. Thereafter, COGS is expected to remain at a constant percentage of Sales. Because operating efficiency is expected to improve each year, SG&A expense is expected to remain at $950,000 for each of the five years of the project. At the end of the project’s five-year life, production will cease, and the manufacturing line will be sold for an estimated $140,000. At that time, Inventory, Accounts Receivable and Accounts Payable will return to their pre-project levels.
If the project is implemented, it will likely cannibalize sales of an existing product. The net impact of the cannibalization is expected to be a $225,000 annual reduction in pre-tax profits.
Your employer’s tax rate is 21%. The firm has 2 million shares of common stock outstanding. The firm requires a 14% rate of return on capital projects.
Prepare a discounted cash flow analysis to determine whether your employer should implement this capital project. Your analysis should reveal answers to each of the following questions. Highlight the cells that answer the following questions:
Please include all the formulas used in answer
(1) Initial Investment Amount:
Particulars | Amount |
Cost of installing a new manufacturing line | $ 1,880,000 |
Changes in working capital (Note 1) | $ 390,000 |
Total initial investment | $ 2,270,000 |
(2) Calculation of total cashflow each year:
Particulars | Year 1 | Year 2 | Year 3 | Year 4 | Year 5 |
Sales |
$ 3,375,000 ($3,375,000*1) |
$ 3,575,500 ($3,375,000*1.06) |
$ 3,792,150 ($3,575,500*1.06) |
$ 4,019,680 ($3,792,150*1.06) |
$ 4,260,860 (4,019,679*1.06) |
Less: | |||||
COGS (47.40% of sales) |
($ 1,599,600) |
($ 1,694,787) (sales x 47.4%) |
($ 1,797,479) (sales x 47.4%) |
($ 1,905,328) (sales x 47.4%) |
($ 2,019,648) (sales x 47.4%) |
Selling, General and Admin Expenses | ($ 950,000) | ($ 950,000) | ($ 950,000) | ($ 950,000) | ($ 950,000) |
Depreciation (Note 2) | ($ 426,000) | ($ 426,000) | ($ 426,000) | ($ 426,000) | ($ 426,000) |
Cannibalization impact | ($ 225,000) | ($ 225,000) | ($ 225,000) | ($ 225,000) | ($ 225,000) |
Add: | |||||
Recovery of working capital | NIL | NIL | NIL | NIL | $ 390,000 |
Residual value of mfg line | NIL | NIL | NIL | NIL | $ 140,000 |
Cash flow before tax | $ 174,400 | $ 279,713 | $ 393,671 | $ 513,352 | $ 1,170,212 |
Less: Taxes | ($ 36,624) | ($ 58,740) | ($ 82,671) | ($ 107,804) | ($ 245,745) |
Cash flow after tax | $ 137,776 | $ 220,973 | $ 311,000 | $ 405,548 | $ 924,467 |
Add: Depreciation | $ 426,000 | $ 426,000 | $ 426,000 | $ 426,000 | $ 426,000 |
(A) Net cash flow after tax | $ 563,776 | $ 646,973 | $ 737,000 | $ 831,548 | $ 1,350,467 |
(B) Discounting factor @ 14% | 0.8772 | 0.7695 | 0.6750 | 0.5921 | 0.5194 |
(C) Discounted cashflow [(A) X (B)] | $ 494,544 | $ 497,486 | $ 497,475 | $ 492,360 | $ 701,433 |
(3) Calculation of NPV:
Total discounted cash inflow = $ 2,683,298
Total initial cash outflow = $ 2,270,000
Net present value = $ 413,298
(4) Calculation of IRR:
Trial & Error Method
@ 14% -------------> $ 2,683,298
@ 21% --------------> $ 2,232,426
We need a value in between these two numbers and that is $ 2,270,000.
Therefor, difference between $ 2,683,298 and $ 2,232,426 is $ 450,872
IRR = 21% - [$ 450,872 / $ 2,232,426] * 21 = 16.76%
Note:
(1) Working capital changes = Account receivable + Inventory - Account payable
= $ 290,000 + $ 260,000 - $ 160,000
= $ 390,000
(2) Depreciation = ($ 2,270,000 - $ 140,000) / 5 years = $ 460,000
(3) Cost of $ 950,000 is a historical cost. Historical cost is not to be considered in capial budgeting as it is already incurred in past.