Question

This exercise parallels the machine-purchase decision for the Mendoza Company that is discussed in the body of the chapter. Assume that Mendoza is exploring whether to enter a complementary line of business. The existing business line generates annual cash revenues of approximately $4,350,000 and cash expenses of $3,675,000, one-third of which are labor costs. The current level of investment in this existing division is $12,800,000. (Sales and costs of this division are not affected by the investment decision regarding the complementary line.)
  
Mendoza estimates that incremental (noncash) net working capital of $34,000 will be needed to support the new business line. No additional facilities-level costs would be needed to support the new line—there is currently sufficient excess capacity. However, the new line would require additional cash expenses (overhead costs) of $434,000 per year. Raw materials costs associated with the new line are expected to be $1,360,000 per year, while the total labor cost is expected to double.
  
The CFO of the company estimates that new machinery costing $3,700,000 would need to be purchased. This machinery has a six-year useful life and an estimated salvage (terminal) value of $592,000. For tax purposes, assume that the Mendoza Company would use the straight-line method (with estimated salvage value considered in the calculation).

Assume, further, that the weighted-average cost of capital (WACC) for Mendoza is 14% (after-tax) and that the combined (federal and state) income tax rate is 45%. Finally, assume that the new business line is expected to generate annual cash revenue of $3,975,000.

Answer 1