Question

1. McCormick & Company is considering purchasing a new factory in Largo, Maryland. The purchase price of the factory is $750,000. The investment value of the factory is $868,080. What is the net present value?

2. If McCormick & Company decides to purchase the new factory in Largo, they need to consider relevent after-tax cash flow. McCormick & Company estimated their potential first-year sales revenue at $600,000, expenses at $225,000, and depreciation expense at $150,000. McCormick's marginal tax rate is 40 percent (21 percent federal and 19 percent state combined). What is first-year relative cash flow?

Answer is $285,000

3. The estimated relevent annual expected cash flows (C1) associated with the puchase of the new factory in Largo are as follows: Year C1 PV(C1) 1 ? ? 2 $291,000 $202,083 3 $191,000 $110,532 4 $306,000 $147,569 5 $424,000 $170,396 In year 3, the estimated relevent annual expected cash flows represents funds used to pay operating expenses for subsequent years. All estimated relevent annual expected cash flows include a risk premium of 13 percent, which has already been applied to the cash flows above. Solve for cash flow for Year 1 based on your answer in Question 2. Then, solve for present value (PV) for Year 1. What is the total of present value for all five years? Should the factory be purchased? Why or why not?

4. McCormick & Company is also considering introducing two new product lines to be made at the new factory (if it is purchased). As a new member of MCS's finance team, you are asked to determine whether McCormick & Company should invest in the two product line expansions. Project A has lower future cash flows than Project B, but because Project A is more closely related to McCormick's existing product line, the company feels it is less risky than Project B. You’ve done some more analysis and have formulated the following future profits for each project (with the first cash flow occurring one year from now). Each project is expected to have a life of 5 years. Year 1 Year 2 Year 3 Year 4 Year 5 Project A $5M $10M $10M $15M $15M Project B $5M $10M $15M $20M $20M You also believe that each project will require about $40 million in upfront investment. Finally, based on the different risk assumptions, you believe that Project A should use a discount rate of 7 percent, while Project B will have a discount rate of 20 percent. Which project or projects should the company undertake?

Answer 1

1. Net Present Value = $868080 - $750,000 = $118,080

2. Calculation of Relative Cash flow

	Particulars	Amount
	Sale revenue	600000
Less:	Expeneses	225000
Less:	Depreciation	150000
	Profit before tax	225000
Less:	Tax @ 40%	90000
	Profit after tax	135000
Add:	Depreciation	150000
	Relative CF	285000

4. NPV of Project A

Year	Cash Flow	PVF @ 7%	P.V
0	(40,000,000.00)	1	(40,000,000.00)
1	5,000,000.00	0.93457944	4,672,897.20
2	10,000,000.00	0.87343873	8,734,387.28
3	10,000,000.00	0.81629788	8,162,978.77
4	15,000,000.00	0.76289521	11,443,428.18
5	15,000,000.00	0.71298618	10,694,792.69
		NPV	3,708,484.12

NPV of Project B

Year	Cash Flow	PVF @ 20%	P.V
0	(40,000,000.00)	1	(40,000,000.00)
1	5,000,000.00	0.83333333	4,166,666.67
2	10,000,000.00	0.69444444	6,944,444.44
3	15,000,000.00	0.5787037	8,680,555.56
4	20,000,000.00	0.48225309	9,645,061.73
5	20,000,000.00	0.40187757	8,037,551.44
		NPV	(2,525,720.16)

Since NPV of project A is positive so Project A should be undertaken.