Question

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 $5,400,000 and cash expenses of $3,780,000, one-third of which are labor costs. The current level of investment in this existing division is $12,450,000. (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 $44,500 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 $462,000 per year. Raw materials costs associated with the new line are expected to be $1,570,000 per year, while the total labor cost is expected to double.
  
The CFO of the company estimates that new machinery costing $4,400,000 would need to be purchased. This machinery has a four-year useful life and an estimated salvage (terminal) value of $704,000. 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 13% (after-tax) and that the combined (federal and state) income tax rate is 25%. Finally, assume that the new business line is expected to generate annual cash revenue of $4,500,000.

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

1. Net cash outflow, project initiation (time period 0)
Cost of new machine	$4,400,000
Incremental working capital required	$44,500
Total	$4,444,500

2. Annual after-tax cash inflow, project operation (time period 1 through 4)
Incremental cash revenue		$4,500,000
Incremental cash expenses:
Overhead	$462,000
Raw material	$1,570,000
Labor ($3,780,000 ×1/3)	$1,260,000
Incremental non- cash expenses:
Depreciation (straight line basis) ; ($4,400,000 - $704,000)/4 ; $3,696,000/4 = $924,000	$924,000	$4,216,000
Incremental operating income		$284,000
Less: income tax (@25%), ($284,000 ×25%)		$71,000
After tax operating income		$213,000
Add: Non cash charges (Depreciation)		$924,000
Annual after-tax cash inflow		$1,137,000

3. Project termination (end of year 4)
Recovery of incremental investment in net working capital		$44,500
Salvage value of machine:
Estimated terminal value	$704,000
Tax effect (@25%)	$0	$704,000
		$748,500