Question

In: Accounting

Footer Inc: Replacing the broken Machine Footer Inc, a manufacturer of T-shirts, had seen its production...

Footer Inc: Replacing the broken Machine

Footer Inc, a manufacturer of T-shirts, had seen its production line slow to a halt when one of the company’s twomachines had broken down. If capacity increased, estimated sales revenues would rise by at least $50,000 per month due to unmet demand and increased efficiency. COGS on the additional revenues were expected to be 65% monthly. The company’s management, saw 2 viable options to increase capacity:

OPTION 1: PURCHASE A NEW MACHINE

The cost of the new machine would be $142,000. Also there would be operating costs of $140,000 per year. These include $20.000 depreciation. After five years, the machine would have a salvage value of $40,000. Cost of capital is 6%.

OPTION 2: PURCHASE A SECOND HAND MACHINE

The company selling the machine also offers second hands machines. The cost of a second hand machine would be $60,000. Useful life three years. After three years the machine would have a salvage value of $40.000. The operating costs and cost of capital are the same as option 1.

REQUIRED

  1. Use NPV and PP calculations to analyze each option. (start with identifying the cash inflows and cash outflows). USE THE XL-SHEET

  2. Make a well-reasoned recommendation for the company’s management backed up by your analysis. c.a. 100 words TYPE YOUR ANSWER IN THE XL SHEET

  3. After acquiring the machine, Footer Inc decided to grow its business and open an additional plant. In order to finance this, the company issued 4 million ordinary shares at market value $1,0 and took a bank loan of $2 million at an interest rate of 10%. The required rate of return by investors is 15%. Tax rate is 30%. Calculate the WACC. TYPE YOUR ANSWER IN THE XL SHEET

  4. Upload an Excel spreadsheet OR use the indirect method showing the cash flows of the investment for the $400.000 investment.

  5. Estimate/calculate the overall rate of return (WACC) for the $ 400.000 investment based on your personal assumptions. How are you going to finance this investment?

Solutions

Expert Solution

Based on NPV Method, New machine is to be purchased as NPV of New Machine is higher than older machine.

=2000/17500

= 0.1143

Therefore, in total Payback period is 8.1143 Months.

=7500 / 17500

= 0.4286

Therefore, in total Payback period is 3.4286 Months.

Thus, Payback method method suggest Old machine should be purchased as it has lower payback period than new machine.

As we can see the opinion for both the methods is having different opinion. As is contradiction in both the methods keen study should be made before purchase of the machine. Based on companies requirements decision can be taken to purchase old or new machine.

As the matter of fact, payback method do not take into consideration discount factor of cashflows. NPV calculate exactly value of gains in dollars in whole project considering all the cashflow. hence NPV method can be considered more reliable.

WACC = Equity/Equity+Debt * required Return on equity + Debt/Equity+Debt *Cost of Debt * (1-Tax)

=40/60*0.15+20/60*0.1* (1-0.3)

=12.33 %

The below Part is not clear to give the answer

  1. Upload an Excel spreadsheet OR use the indirect method showing the cash flows of the investment for the $400.000 investment.

  2. Estimate/calculate the overall rate of return (WACC) for the $ 400.000 investment based on your personal assumptions. How are you going to finance this investment?


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