Question
In: Accounting
Geraldine Price, the manager of Household Products has asked Doreen Spencer to analyze the possibility of...
- Geraldine Price, the manager of Household Products has asked Doreen Spencer to analyze the possibility of introducing a new product WS -500. The product will have a useful life of six years after which the product will be replaced.
WS-500 will require special-purpose equipment costing $1,200,000. The useful life of the equipment is six years and an estimated terminal disposal price of $600,000. The equipment qualifies for 25% CCA rate.
The product will be produced in a plant which is currently being leased to another business for $60,000 per year. The lease has 6 years remaining. The lease contains a cancellation clause whereby the landlord can obtain immediate possession of the premises upon payment of $42,000 cash.
The old plant has a book value of $300,000 and is being amortized for accounting purposes on a straight-line basis at $30,000 annually.
Certain nonrecurring market research studies and sales promotion activities will amount to a cost of $375,000 at the end of year 1. The entire amount is deductible in full for income tax purposes in the year expenditure.
Additions to working capital will require $260,000 at the outset and an additional $240,000 at the end of two years.
Net cash inflow from operations before amortization and income taxes is expected to be $480,000 in years 1 and 2, $720,000 in years 3 to 5, and $400,000 in year 6.
Tax rate is 25% and cost of capital is 16%
Required:
- Recommend if Household Products recommend launching WS-500?
Solutions
Expert Solution
| CASH INFLOW | ||||||
| DISCOUNTED VALUE OF CASH INFLOW | $ 17,71,873.56 | SEE W N 1 | ||||
| DISCOUNTED VALUE OF DISPOSAL PRICE | $ 2,46,265.35 | SEE W N 2 | ||||
| TOTAL CASH INFLOW | $ 20,18,138.91 | |||||
| CASH OUTLAY | ||||||
| COST OF SPECIAL PURPOSEEQUIPMENT | $ 12,00,000.00 | |||||
| LEASE CANCELLATION COST | $ 42,000.00 | |||||
| OPPURTUNITY COST OF LEASE CANCELLATION | $ 2,21,084.15 | SEE W N 3 | ||||
| MARKET RESEARCH EXPENSES AFTER TAX | $ 2,81,250.00 | (375000*.75) | ||||
| ADDITIONAL WORKING CAPITAL AT OUTSET | $ 2,60,000.00 | |||||
| WORKING CAPITAL AFTER 2 YEARS | $ 1,78,359.10 | (240000*.74316) | ||||
| DISCOUNTED VALUE OF TAX ON DISPOSAL OF ASSET | $ 39,651.37 | SEE W N 4 | ||||
| TOTAL CASH OUTFLOW | $ 22,22,344.62 | |||||
| NET PRESENT VALUE | -$ 2,04,205.71 | |||||
| DECISSION: NET PRESENT VALUE OF THE NEW PRODUCT IS | -$ 2,04,205.71 | |||||
| ie,CASH INFLOW IS LESS THAN CASH OUTFLOW SO IT IS NOT ADVISABLE TO LAUNCH WS-500 | ||||||
| W N 1 | ||||||
| year | Cash inflow | Tax @25% | CASH FLOW AFTER TAX | PVF@16% | DISCOUNTED CASH FLOW | |
| 1 | $ 4,80,000.00 | $ 45,000.00 | $ 4,35,000.00 | $ 0.86 | $ 3,75,000.00 | |
| 2 | $ 4,80,000.00 | $ 63,750.00 | $ 4,16,250.00 | $ 0.74 | $ 3,09,341.56 | |
| 3 | $ 7,20,000.00 | $ 1,37,812.50 | $ 5,82,187.50 | $ 0.64 | $ 3,72,982.89 | |
| 4 | $ 7,20,000.00 | $ 1,48,359.38 | $ 5,71,640.63 | $ 0.55 | $ 3,15,712.03 | |
| 5 | $ 7,20,000.00 | $ 1,56,269.53 | $ 5,63,730.47 | $ 0.48 | $ 2,68,399.41 | |
| 6 | $ 4,00,000.00 | $ 82,202.15 | $ 3,17,797.85 | $ 0.41 | $ 1,30,437.67 | |
| $ 17,71,873.56 | ||||||
| W N 2 | W N 3 | |||||
| DISPOSAL PRICE | $ 6,00,000.00 | OPPORTUNITY COST OF LEASE CANCELLATION | ||||
| DISCOUNTED VALUE OF DISPOSAL PRICE | $ 2,46,265.35 | (600000*.41044) | $ 60,000.00 | $ 0.86 | $ 51,724.14 | |
| $ 60,000.00 | $ 0.74 | $ 44,589.77 | ||||
| $ 60,000.00 | $ 0.64 | $ 38,439.46 | ||||
| $ 60,000.00 | $ 0.55 | $ 33,137.47 | ||||
| $ 60,000.00 | $ 0.48 | $ 28,566.78 | ||||
| $ 60,000.00 | $ 0.41 | $ 24,626.54 | ||||
| $2,21,084.15 | ||||||
| W N 4 | ||||||
| PROFIT ON SALE OF SALE EQUIPMENT | $ 3,86,425.78 | |||||
| TAX ON PROFIT | $ 96,606.45 | |||||
| DISCOUNTED VALUE OF TAX | $ 39,651.37 | |||||
| COPUTATION OF TAX | ||||||
| year | Cash inflow | depreciation@25% | cash inflow after amortization | Tax @25% | ||
| 1 | $ 4,80,000.00 | $ 3,00,000.00 | $ 1,80,000.00 | $ 45,000.00 | ||
| 2 | $ 4,80,000.00 | $ 2,25,000.00 | $ 2,55,000.00 | $ 63,750.00 | ||
| 3 | $ 7,20,000.00 | $ 1,68,750.00 | $ 5,51,250.00 | $ 1,37,812.50 |
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