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 $4,410,000 and cash expenses of $3,681,000, one-third of which are labor costs. The current level of investment in this existing division is $12,850,000. (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 $36,500 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 $437,000 per year. Raw materials costs associated with the new line are expected to be $1,400,000 per year, while the total labor cost is expected to double.
  
The CFO of the company estimates that new machinery costing $3,600,000 would need to be purchased. This machinery has a seven-year useful life and an estimated salvage (terminal) value of $576,000. 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 15% (after-tax) and that the combined (federal and state) income tax rate is 42%. Finally, assume that the new business line is expected to generate annual cash revenue of $4,035,000.

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

Estimation of Cash Flow After Tax for Complementary Business
Purchas value of Machine	3,600,000.00
Working Initial Working Capital Requirement	36,500.00
Project Initial Requirement	3,636,500.00
Revenue Per Year	4,035,000.00
Raw Material Cost	1,400,000.00
Labour Cost	1,227,000.00
Cash Overhead Expenses	437,000.00
Earning Before depreciation, Interest and Tax (EBDIT)	971,000.00
Machinery Depreciation	432,000.00
Earning Before Interest and Tax (EBIT)	539,000.00
Interest	-
Tax 42%	226,380.00
Earning After Tax	312,620.00
Depreciation	432,000.00
Yearly Cash inflow generation	744,620.00
Cumulative present value factor	4.16
Cumulative Cash flow generation over seven year	3,097,931.74
Yearly Cost of Capital @15%	1	2	3	4	5	6	7
PVF	0.87	0.76	0.66	0.57	0.50	0.43	0.38
Value Realised at the end of 7th Year
Realisable value of Machinery	576,000.00
Working Capital Initially inserted	36,500.00
Total realisable value	612,500.00
Present value factor at 7th Year end	0.38
Present value of value realised at 7th year	230,261.44
Net Present Value of Complementary Business
Cumulative Cash flow generation over seven year	3,097,931.74
Present value of value realised at 7th year	230,261.44
Total Cash Inflow	3,328,193.18
Total Cash Outflow	3,636,500.00
Net Present Value of Complementary Business	(308,306.82)
Conclusion: As per above analysis, we should enter in complementary business.