Question

Unilate Textiles is evaluating a new product, a silk/wool blended fabric. Assume that you were recently hired as assistant to the director of capital budgeting, and you must evaluate the new project.

The fabric would be produced in an unused building adjacent to Unilate’s Southern Pines, North Carolina plant. Unilate owns the building, which is fully depreciated. The required equipment would cost $200,000, plus an additional $40,000 for shipping and installation. In addition, inventories would rise by $25,000, while accounts payable would go up by $5,000. All of these costs would be incurred at Year 0. By a special ruling, the machinery could be depreciated under the MACRS system as 3-year property. (See Table 10A.2 at the end of Chapter 10 for MACRS recovery allowance percentages.)

The project is expected to operate for four years, at which time it will be terminated. The cash inflows are assumed to begin one year after the project is undertaken, or at t = 1, and to continue out to t = 4. At the end of the project’s life (Year 4), the equipment is expected to have a salvage value of $25,000.

Unit sales are expected to total 100,000 five-yard textile rolls per year, and the expected sales price is $2 per roll. Cash operating costs for the project (total operating costs less depreciation) are expected to total 60% of dollar sales. Unilate’s marginal tax rate is 40%, and its required rate of return is 10%. Tentatively, the silk/wool blend fabric project is assumed to be of equal risk to Unilate’s other assets.

You have been asked to evaluate the project and to make a recommendation as to whether it should be accepted or rejected. To guide you in your analysis, your boss gave you the following set of tasks to complete:

Unilate’s Silk/Wool Fabric Project ($ Thousands)

      End of Year:                                         0                1                    2                3             4      

      Unit sales (Thousands)                                                                    100                                   

      Price/unit                                                              $ 2.00          $ 2.00                                      

      Total revenues                                                                                                $200.0                

      Costs excluding depreciation                                                   ($120.0)                                  

      Depreciation                                                                                                   ( 36.0)     ( 16.8)

        Total operating costs                                        ($199.2)        ($228.0)                                  

        Earnings before taxes (EBT)                                                                       $44.0

        Taxes                                                                 (     0.3)                                               25.3

        Net income                                                                                                  $26.4

      Depreciation                                                              79.2                                  36.0                

        Supplemental operating CF                                  $ 79.7                                             $ 54.7

      Equipment cost

      Installation

      Increase in inventory

      Increase in accounts payable

      Salvage value

      Tax on salvage value

      Return of net working capital                                                                                                     

      Cash flow timeline (net CF):             ($260.0)                                                               $ 89.7

      Cumulative CF for payback:               ( 260.0)       ( 180.3)                                               63.0

                            NPV =

                             IRR =

                    Payback =

Complete the table in the following order:

(1) Complete the unit sales, sales price, total revenues, and operating costs excluding depreciation lines.

(2) Complete the depreciation line.

(3) Now complete the table down to net income and then down to net operating cash flows.

(4) Now fill in the blanks under Year 0 and Year 4 for the initial investment outlay and the terminal cash flows and complete the cash flow time line (net CF). Discuss working capital. What would have happened if the machinery were sold for less than its book value?

Answer 1

Working Capital = 25000-5000 = 20000

If machinery was sold for less than its book value, then they would have got higher depreciation benefit in the last year, thereby reducing tax but salvage cashflows as well. At last overall NPV and IRR must had gone down