Question

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 PROVIDED

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 PROVIDED

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 PROVIDED

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?

Answer 1

		Present Value(PV) of Cash Flow:
		(Cash Flow)/((1+i)^N)
		i=discount rate =Cost of Capital=`6%=0.06
		N=Year   of Cash Flow
		Annual increase in revenue=50000*12	$600,000
		Additional expenses =65%*600000	$390,000
		Increase in annual contribution	$210,000
		Tax rate is not mentioned , hence it is not considered
		CASH FLOW ANALYSIS OF OPTION1: NEW MACHINE
	N	Year	0	1	2	3	4	5
	A	Total initial cash flow	-$142,000
	b	Annual Contribution increase		$210,000	$210,000	$210,000	$210,000	$210,000
	c	Operating Costs(Excluding Depreciation)		-$120,000	-$120,000	-$120,000	-$120,000	-$120,000
	D=b+c	Net annual Cash Flow		$90,000	$90,000	$90,000	$90,000	$90,000
	E	Terminal Salvage value						$40,000
	CF=A+D+E	Net Cash Flow	($142,000)	$90,000	$90,000	$90,000	$90,000	$130,000	SUM
	PV=CF/(1.06^N)	Present Value of Net Cash Flow	($142,000)	$84,906	$80,100	$75,566	$71,288	$97,144	$267,003
(a)	NPV=Sum of PV	Present Worth	$267,003
(b)	PMT	Annual Equivalent Worth	$63,386	(Using PMT function of excel with Rate=6%, Nper=5, Pv=-267003)
		CASH FLOW ANALYSIS OF OPTION2: OLD MACHINE
	N	Year	0	1	2	3
	A	Total initial cash flow	-$60,000
	b	Annual Contribution increase		$210,000	$210,000	$210,000
	c	Operating Costs(excluding depreciation)		-$120,000	-$120,000	-$120,000
	D=b+c	Net annual Cash Flow		$90,000	$90,000	$90,000
	E	Terminal Salvage value				$40,000
	CF=A+D+E	Net Cash Flow	($60,000)	$90,000	$90,000	$130,000	SUM
	PV=CF/(1.06^N)	Present Value of Net Cash Flow	($60,000)	$84,906	$80,100	$109,151	$214,156
(a)	NPV=Sum of PV	Present Worth	$214,156
(b)	PMT	Annual Equivalent Worth	$80,118	(Using PMT function of excel with Rate=6%, Nper=3, Pv=-214156)
		Option 2(OLD Machine) has higher annual worth
		Option 2(OLD Machine) is RECOMMENDED