Question

Exercise 12-28 Identifying Relevant Cash Flows; Asset-Purchase Decision [LO 12-3] 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 $5,000,000 and cash expenses of $3,600,000, one-third of which are labor costs. The current level of investment in this existing division is $12,000,000. (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 $30,000 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 $400,000 per year. Raw materials costs associated with the new line are expected to be $1,200,000 per year, while the total labor cost is expected to double. The CFO of the company estimates that new machinery costing $2,500,000 would need to be purchased. This machinery has a seven-year useful life and an estimated salvage (terminal) value of $400,000. 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 40%. Finally, assume that the new business line is expected to generate annual cash revenue of $3,600,000. Required: Determine relevant cash flows (after-tax) at each of the following three points: (1) project initiation, (2) project operation, and (3) project disposal (termination). For purposes of this last calculation, you can assume that the asset is sold at the end of its useful life for the salvage value used to establish the annual straight-line depreciation deductions; further, you can assume that at the end of the project’s life Mendoza will fully recover its initial investment in net working capital. Exercise 12-28 Identifying Relevant Cash Flows; Asset-Purchase Decision [LO 12-3] 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 $5,000,000 and cash expenses of $3,600,000, one-third of which are labor costs. The current level of investment in this existing division is $12,000,000. (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 $30,000 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 $400,000 per year. Raw materials costs associated with the new line are expected to be $1,200,000 per year, while the total labor cost is expected to double. The CFO of the company estimates that new machinery costing $2,500,000 would need to be purchased. This machinery has a seven-year useful life and an estimated salvage (terminal) value of $400,000. 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 40%. Finally, assume that the new business line is expected to generate annual cash revenue of $3,600,000. Required: Determine relevant cash flows (after-tax) at each of the following three points: (1) project initiation, (2) project operation, and (3) project disposal (termination). For purposes of this last calculation, you can assume that the asset is sold at the end of its useful life for the salvage value used to establish the annual straight-line depreciation deductions; further, you can assume that at the end of the project’s life Mendoza will fully recover its initial investment in net working capital. Exercise 12-28 Identifying Relevant Cash Flows; Asset-Purchase Decision [LO 12-3] 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 $5,000,000 and cash expenses of $3,600,000, one-third of which are labor costs. The current level of investment in this existing division is $12,000,000. (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 $30,000 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 $400,000 per year. Raw materials costs associated with the new line are expected to be $1,200,000 per year, while the total labor cost is expected to double. The CFO of the company estimates that new machinery costing $2,500,000 would need to be purchased. This machinery has a seven-year useful life and an estimated salvage (terminal) value of $400,000. 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 40%. Finally, assume that the new business line is expected to generate annual cash revenue of $3,600,000. Required: Determine relevant cash flows (after-tax) at each of the following three points: (1) project initiation, (2) project operation, and (3) project disposal (termination). For purposes of this last calculation, you can assume that the asset is sold at the end of its useful life for the salvage value used to establish the annual straight-line depreciation deductions; further, you can assume that at the end of the project’s life Mendoza will fully recover its initial investment in net working capital.

Answer 1

Answer

Determination of Relavant Cash Flows

1. Cash flows during Project Initiation (Year 0)

Cash Inflow					Nil
Cash outflow					$
1	Incremental networking capital				30,000
2	Machinery				2500000

2. Cash flows during Project Operation (Year 1 to 7)

					$
Total revenue					36,00,000
Less:
	Cash expenses				4,00,000
	Raw materail costs				12,00,000
	Labour cost (Expected to double) Working Note 1				12,00,000
	Total costs				28,00,000
Net cash inflows					8,00,000
Less: Depreciation Working Note 2					3,00,000
Net taxable value					5,00,000
Less: Tax out flow (40%)					2,00,000
Inflows after taxes					3,00,000
Add: Depreciation (Non cash item)					3,00,000
Net annual cash inflow during project operation					6,00,000

Working Notes

1. Presnt labour cost is 1/3 of 3600000. i.e. 1,200,000. The same is expected to be doubled after new project line. Therefore, net incremental labour cost is 1,200,000.

2. New machinery cost is $2,500,000.The machinery has a seven-year useful life and an estimated salvage (terminal) value of $400,000. Including terminal value into depreciation calculation, the yearly depreciation is $ 300, 000. i.e. (2,500,000-400,000) / 7 years.

3. Cash flows during Project termination (Year 8)

			$
Sale of machinery			4,00,000
Less: tax @40%			160,000
Net proceeds			2,40,000
Add: Working capital recovered			30,000
Net inflows on termination			2,70,000

Note: Please tote that, to decide whether to take up the new line or not, we shall use Net Present Value of all the cash flows. To calculate the Net present value, we need to discount the yearly cash flows with companies WACC. The same exercise is not being done because the question is not asking us to decide on the viability of new line of business.

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Please revert for any clarifications,.