Question

Central Food Inc., is considering replacing its current production line to improve efficiency. The new production line will cost $650,000 plus $50,000 for shipping and installation. The current production line has a book value of $0 and an estimated market value of $119,666.67. CF uses straight-line depreciation method and has a marginal tax rate of 25% for net income and capital gain.

CF’s current annual sales is $433,000 and by estimation, the new production line can increase CF’s annual sales by about 28%. NWC will rise by $35,000. And due to higher maintenance cost, the operating costs will rise by $15,000 each year. In 11 years the production line currently under consideration can be sold for $110,000.

CF’s require rate of return is 11%.

3) Find the discounted payback period. If the threshold is 4.5 years, should CF accept his project? [20 pts]

(please show equations used, how it is worked out, and explain)

Answer 1

Important : please Note As question says 25% tax on net income and capital gain.hence on instances of sale where capital gain arises 25% tax has to be charged.

Step1

Net Cash outflow= Purchase price- net gain sale of production line rise in working capital

                                =(650000+50000)-89750+35000

                                =$645250

net gain sale of production line=Market value-cost(1-tax)

                                                                =(119666.667-0)*(1-25%)

                                                                =$89750

Step2

Net inflow before tax=Revenue increase-cost increase-depreciation

                                                                                =121240-15000-53636= $52604

Working Sale=(433000*28%)

Depreciation=COST-RESIDUALVALUE/n

                =700000-110000/11

              =$53636

Step3

Net inflow after tax=(Net inflow before tax)(1-tax)

Net inflow after tax=52604*(1-25%)=$39453     

Cash inflow=net inflow after tax+depreciation

=39453+53636= $93089

Step4

Residual value at the end of 11 th year

Residual value on sale(1-tax) + recovery of working capital

110000(1-25%)+35000

82500+35000

=$117500

Step5.Answer to part 3 asked

Calculation of discounted pay back period

Pay back period is when the investment is recovered.For discounted pay back we use present value.

Excel snapshot

Answer=As cumulative present value shows thae cost has not been recovered yet till 11years hence Discounted Pay back period is more than 11years therefore if threshhold is 4.5years Project is not acceptable as cost is not recovered

Formula for Part 3 above

I request you to ask any doubt related to the solution any figure or formula not clear i will reply and answer.Kindly upvote it helps me.Good luck.