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 $4,530,000 and cash expenses of $3,693,000, one-third of which are labor costs. The current level of investment in this existing division is $12,950,000. (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 $41,500 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 $443,000 per year. Raw materials costs associated with the new line are expected to be $1,480,000 per year, while the total labor cost is expected to double.
  
The CFO of the company estimates that new machinery costing $3,630,000 would need to be purchased. This machinery has a nine-year useful life and an estimated salvage (terminal) value of $580,800. 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 11% (after-tax) and that the combined (federal and state) income tax rate is 43%. Finally, assume that the new business line is expected to generate annual cash revenue of $4,155,000.

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.

1)

Determine relevant cash flow (after-tax) at project initiation.

	After-tax cash flow at project initiation (i.e., time period 0)

2)

Determine relevant cash flow (after-tax) at project operation. (Do not round intermediate calculations.)

	Annual After-tax Cash Inflow (time periods 1 through 9): Incremental cash revenues Incremental cash expenses: Incremental non-cash expenses: Incremental operating income After-tax operating income Annual after-tax cash inflow

3)

Determine relevant cash flow (after-tax) at project disposal (termination).

	After-tax cash flow at project termination (end of year 9)

Answer 1

1) Relevant cash flow (after-tax) at project initiation:-

Machinery	$ -3,630,000
Net Working Capital	$ -41,500
cash flow (after-tax) at project initiation	$ -3,671,500

2)

Annual after-tax cash inflow (time periods 1 through 9):

Cash Revenue	$   4,155,000
Cash Expenses (overhead cost)	$     -443,000
Raw Materials	$ -1,480,000
Labor Cost (3,693,000 / 3)	$ -1,231,000
Cash Outflows before tax	$   1,001,000
Depreciation Expenses	$ -338,800
Taxable Income	$      662,200
Income Tax @43%	$ 284746
Annual after-tax cash inflow	$ 377,454

Depreciation = ($3,630,000 - $580,800) / 9 = $338,800 per year

3) Cash flow (after-tax) at project disposal (termination) (end of year 9)

Salvage Value	$ -580,800
Net Working Capital	$ -41,500
Cash flow (after-tax) at project disposal (end of year 9)	$ -622,300

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