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.

Answer 1

Step 1: Formulas and basic calculation used

Depreciation :Machine value/ life of the machine = 3630000/9 =$ 403333

Present value formula : cash flow after tax/( 1 + interest rate ) ^ (no of years)

Labor cost has doubled and it was initially one third of $3693000

So, added labor cost = 1/3 * 3693000 = $1231000

Step 2: Year 0 is the project initiation, from 1-8 is project operation stage and 9 is the project disposal stage.

New Business Line	Project Initiation	Project Operation	Project Disposal
	0	1	2	3	4	5	6	7	8	9
Net Working Capital	-41500									41500
Additional cash expenses		-443000	-443000	-443000	-443000	-443000	-443000	-443000	-443000	-443000
Raw Material cost		-1480000	-1480000	-1480000	-1480000	-1480000	-1480000	-1480000	-1480000	-1480000
Labour cost		-1231000	-1231000	-1231000	-1231000	-1231000	-1231000	-1231000	-1231000	-1231000
Machinery cost	-3630000
Salvage value										580800
Annual cash revenue		4155000	4155000	4155000	4155000	4155000	4155000	4155000	4155000	4155000
Net Cash flow	-3671500	1001000	1001000	1001000	1001000	1001000	1001000	1001000	1001000	1623300
Depreciation		403333	403333	403333	403333	403333	403333	403333	403333	403333
Cash flow for tax	-3671500	597667	597667	597667	597667	597667	597667	597667	597667	1219967
Tax (43%)	0	256997	256997	256997	256997	256997	256997	256997	256997	524586
Cash flow after tax (Cash flow foe tax - Tax + Dep.)	-3671500	744003	744003	744003	744003	744003	744003	744003	744003	1098714
Present value of cash flow (at 11%)	-3671500	670273	603850	544009	490098	441530	397774	358355	322843	429515
NPV value	586747

Hence the Project is Executable, as it has positive NPV which is the sum of all the present value of cash flows

Therefore,

(1) Project intiation stage cash flow : - $3671500

(2) Project operation stage cash flow : $3828732

(3) Project disposal : $429515

Note- Figures are rounded off to the nearest Dollar.