Question
In: Finance
Central Food Inc., is considering replacing its current production line to improve efficiency. The new production...
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%.
For this replacement project:
1) Find initial investment and all the future incremental cash flows.
** ignore the depreciation on the old production line when finding the “increase in depreciation” for this replacement project.
2) Put all cash flows in #1 on a timeline.
3) Find the discounted payback period. If the threshold is 4.5 years, should CF accept his project?
4) Find the net present value. Should CF accept this project?
5) Find the profitability index. Should CF accept this project?
6) Find the modified internal rate of return. Should CF accept this project?
Solutions
Expert Solution
1)
| Particulars | 0 | 1 | 2 | 3 | 4 | 5 | 6 | 7 | 8 | 9 | 10 | 11 |
| New Production Line Cost | -700000 | |||||||||||
| Old Machine Sale after Tax | 89750 | |||||||||||
| Incremental Sales | 121240 | 121240 | 121240 | 121240 | 121240 | 121240 | 121240 | 121240 | 121240 | 121240 | 231240 | |
| Interest on additional Working capital | -3850 | -3850 | -3850 | -3850 | -3850 | -3850 | -3850 | -3850 | -3850 | -3850 | -3850 | |
| Increase in Operating Cost | -15000 | -15000 | -15000 | -15000 | -15000 | -15000 | -15000 | -15000 | -15000 | -15000 | -15000 | |
| Incremental Depriciation SLM 11 yrs | -63636.4 | -63636.4 | -63636.4 | -63636.4 | -63636.4 | -63636.4 | -63636.4 | -63636.4 | -63636.4 | -63636.4 | -63636.4 | |
| Incremental Profit before Tax | 38753.64 | 38753.64 | 38753.64 | 38753.64 | 38753.64 | 38753.64 | 38753.64 | 38753.64 | 38753.64 | 38753.64 | 148753.6 | |
| Tax on above | -9688.41 | -9688.41 | -9688.41 | -9688.41 | -9688.41 | -9688.41 | -9688.41 | -9688.41 | -9688.41 | -9688.41 | -37188.4 | |
| Cash flows | -610250 | 29065.23 | 29065.23 | 29065.23 | 29065.23 | 29065.23 | 29065.23 | 29065.23 | 29065.23 | 29065.23 | 29065.23 | 111565.2 |
0 represents Initial out flow. In absence of information on life of new asset it is assumed as 11 years. Outflow representended in negative and Inflows in positive.
2)
Cashflows on Timeline
| Particulars | 0 | 1 | 2 | 3 | 4 | 5 | 6 | 7 | 8 | 9 | 10 | 11 |
| New Production Line Cost | -700000 | |||||||||||
| Old Machine Sale after Tax | 89750 | |||||||||||
| Incremental Sales | 121240 | 121240 | 121240 | 121240 | 121240 | 121240 | 121240 | 121240 | 121240 | 121240 | 231240 | |
| Interest on additional Working capital | -3850 | -3850 | -3850 | -3850 | -3850 | -3850 | -3850 | -3850 | -3850 | -3850 | -3850 | |
| Increase in Operating Cost | -15000 | -15000 | -15000 | -15000 | -15000 | -15000 | -15000 | -15000 | -15000 | -15000 | -15000 | |
| Incremental Depriciation SLM 11 yrs | -63636.4 | -63636.4 | -63636.4 | -63636.4 | -63636.4 | -63636.4 | -63636.4 | -63636.4 | -63636.4 | -63636.4 | -63636.4 | |
| Incremental Profit before Tax | 38753.64 | 38753.64 | 38753.64 | 38753.64 | 38753.64 | 38753.64 | 38753.64 | 38753.64 | 38753.64 | 38753.64 | 148753.6 | |
| Tax on above | -9688.41 | -9688.41 | -9688.41 | -9688.41 | -9688.41 | -9688.41 | -9688.41 | -9688.41 | -9688.41 | -9688.41 | -37188.4 | |
| Cash flows | -610250 | 29065.23 | 29065.23 | 29065.23 | 29065.23 | 29065.23 | 29065.23 | 29065.23 | 29065.23 | 29065.23 | 29065.23 | 111565.2 |
3)
Payback period
| Particulars | 0 | 1 | 2 | 3 | 4 | 5 | 6 | 7 | 8 | 9 | 10 | 11 |
| New Production Line Cost | -700000 | |||||||||||
| Old Machine Sale after Tax | 89750 | |||||||||||
| Incremental Sales | 121240 | 121240 | 121240 | 121240 | 121240 | 121240 | 121240 | 121240 | 121240 | 121240 | 231240 | |
| Interest on additional Working capital | -3850 | -3850 | -3850 | -3850 | -3850 | -3850 | -3850 | -3850 | -3850 | -3850 | -3850 | |
| Increase in Operating Cost | -15000 | -15000 | -15000 | -15000 | -15000 | -15000 | -15000 | -15000 | -15000 | -15000 | -15000 | |
| Incremental Depriciation SLM 11 yrs | -63636.4 | -63636.4 | -63636.4 | -63636.4 | -63636.4 | -63636.4 | -63636.4 | -63636.4 | -63636.4 | -63636.4 | -63636.4 | |
| Incremental Profit before Tax | 38753.64 | 38753.64 | 38753.64 | 38753.64 | 38753.64 | 38753.64 | 38753.64 | 38753.64 | 38753.64 | 38753.64 | 148753.6 | |
| Tax on above | -9688.41 | -9688.41 | -9688.41 | -9688.41 | -9688.41 | -9688.41 | -9688.41 | -9688.41 | -9688.41 | -9688.41 | -37188.4 | |
| Cash flows | -610250 | 29065.23 | 29065.23 | 29065.23 | 29065.23 | 29065.23 | 29065.23 | 29065.23 | 29065.23 | 29065.23 | 29065.23 | 111565.2 |
| PVF @ 11% | 1 | 0.90 | 0.81 | 0.73 | 0.66 | 0.59 | 0.53 | 0.48 | 0.43 | 0.39 | 0.35 | 0.32 |
| PV of Cashflows | -610250 | 26184.89 | 23589.99 | 21252.24 | 19146.17 | 17248.8 | 15539.46 | 13999.51 | 12612.17 | 11362.32 | 10236.32 | 35397.79 |
Payback period
= Initial investment ( 0 ) / Cashflows inflows from project (1 to 11)
= 610250 / 206569.7
= 2.95
Payback period is greater than 1. Project should not be accetpted.
4)
| Particulars | 0 | 1 | 2 | 3 | 4 | 5 | 6 | 7 | 8 | 9 | 10 | 11 |
| New Production Line Cost | -700000 | |||||||||||
| Old Machine Sale after Tax | 89750 | |||||||||||
| Incremental Sales | 121240 | 121240 | 121240 | 121240 | 121240 | 121240 | 121240 | 121240 | 121240 | 121240 | 231240 | |
| Interest on additional Working capital | -3850 | -3850 | -3850 | -3850 | -3850 | -3850 | -3850 | -3850 | -3850 | -3850 | -3850 | |
| Increase in Operating Cost | -15000 | -15000 | -15000 | -15000 | -15000 | -15000 | -15000 | -15000 | -15000 | -15000 | -15000 | |
| Incremental Depriciation SLM 11 yrs | -63636.4 | -63636.4 | -63636.4 | -63636.4 | -63636.4 | -63636.4 | -63636.4 | -63636.4 | -63636.4 | -63636.4 | -63636.4 | |
| Incremental Profit before Tax | 38753.64 | 38753.64 | 38753.64 | 38753.64 | 38753.64 | 38753.64 | 38753.64 | 38753.64 | 38753.64 | 38753.64 | 148753.6 | |
| Tax on above | -9688.41 | -9688.41 | -9688.41 | -9688.41 | -9688.41 | -9688.41 | -9688.41 | -9688.41 | -9688.41 | -9688.41 | -37188.4 | |
| Cash flows | -610250 | 29065.23 | 29065.23 | 29065.23 | 29065.23 | 29065.23 | 29065.23 | 29065.23 | 29065.23 | 29065.23 | 29065.23 | 111565.2 |
| PVF @ 11% | 1 | 0.90 | 0.81 | 0.73 | 0.66 | 0.59 | 0.53 | 0.48 | 0.43 | 0.39 | 0.35 | 0.32 |
| PV of Cashflows | -610250 | 26184.89 | 23589.99 | 21252.24 | 19146.17 | 17248.8 | 15539.46 | 13999.51 | 12612.17 | 11362.32 | 10236.32 | 35397.79 |
NPV = Pv of all cashflow = - 403680
NPV is negative. Project should not be accetpted.
5)
| Particulars | 0 | 1 | 2 | 3 | 4 | 5 | 6 | 7 | 8 | 9 | 10 | 11 |
| New Production Line Cost | -700000 | |||||||||||
| Old Machine Sale after Tax | 89750 | |||||||||||
| Incremental Sales | 121240 | 121240 | 121240 | 121240 | 121240 | 121240 | 121240 | 121240 | 121240 | 121240 | 231240 | |
| Interest on additional Working capital | -3850 | -3850 | -3850 | -3850 | -3850 | -3850 | -3850 | -3850 | -3850 | -3850 | -3850 | |
| Increase in Operating Cost | -15000 | -15000 | -15000 | -15000 | -15000 | -15000 | -15000 | -15000 | -15000 | -15000 | -15000 | |
| Incremental Depriciation SLM 11 yrs | -63636.4 | -63636.4 | -63636.4 | -63636.4 | -63636.4 | -63636.4 | -63636.4 | -63636.4 | -63636.4 | -63636.4 | -63636.4 | |
| Incremental Profit before Tax | 38753.64 | 38753.64 | 38753.64 | 38753.64 | 38753.64 | 38753.64 | 38753.64 | 38753.64 | 38753.64 | 38753.64 | 148753.6 | |
| Tax on above | -9688.41 | -9688.41 | -9688.41 | -9688.41 | -9688.41 | -9688.41 | -9688.41 | -9688.41 | -9688.41 | -9688.41 | -37188.4 | |
| Cash flows | -610250 | 29065.23 | 29065.23 | 29065.23 | 29065.23 | 29065.23 | 29065.23 | 29065.23 | 29065.23 | 29065.23 | 29065.23 | 111565.2 |
| PVF @ 11% | 1 | 0.90 | 0.81 | 0.73 | 0.66 | 0.59 | 0.53 | 0.48 | 0.43 | 0.39 | 0.35 | 0.32 |
| PV of Cashflows | -610250 | 26184.89 | 23589.99 | 21252.24 | 19146.17 | 17248.8 | 15539.46 | 13999.51 | 12612.17 | 11362.32 | 10236.32 | 35397.79 |
Profitability Index = PV of Cashflows ( 1 to 11) / Initial Investment
= 206569.7 / 610250 = 0.3385
Profitability Index is below 1. Project should not be accetpted.
6)
| Particulars | 0 | 1 | 2 | 3 | 4 | 5 | 6 | 7 | 8 | 9 | 10 | 11 |
| New Production Line Cost | -700000 | |||||||||||
| Old Machine Sale after Tax | 89750 | |||||||||||
| Incremental Sales | 121240 | 121240 | 121240 | 121240 | 121240 | 121240 | 121240 | 121240 | 121240 | 121240 | 231240 | |
| Interest on additional Working capital | -3850 | -3850 | -3850 | -3850 | -3850 | -3850 | -3850 | -3850 | -3850 | -3850 | -3850 | |
| Increase in Operating Cost | -15000 | -15000 | -15000 | -15000 | -15000 | -15000 | -15000 | -15000 | -15000 | -15000 | -15000 | |
| Incremental Depriciation SLM 11 yrs | -63636.4 | -63636.4 | -63636.4 | -63636.4 | -63636.4 | -63636.4 | -63636.4 | -63636.4 | -63636.4 | -63636.4 | -63636.4 | |
| Incremental Profit before Tax | 38753.64 | 38753.64 | 38753.64 | 38753.64 | 38753.64 | 38753.64 | 38753.64 | 38753.64 | 38753.64 | 38753.64 | 148753.6 | |
| Tax on above | -9688.41 | -9688.41 | -9688.41 | -9688.41 | -9688.41 | -9688.41 | -9688.41 | -9688.41 | -9688.41 | -9688.41 | -37188.4 | |
| Cash flows | -610250 | 29065.23 | 29065.23 | 29065.23 | 29065.23 | 29065.23 | 29065.23 | 29065.23 | 29065.23 | 29065.23 | 29065.23 | 111565.2 |
MIRR
= ( Future Cash flows / Inital investment ) ^ (1/n) -
n = 11 yrs
= ( 402217.5 / 610250 ) ^ (1/11) - 1
= 0.9628 - 1
= - 0.03719
= - 3.72 %
MIRR is negative. Project should not be accetpted.
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