Question

1. Kirksville Foods Corporation (KFC) currently processes seafood with a unit it purchased three years ago. The unit will be built on the lot that was purchased for $200,000 after-tax last year. The lot is currently appraised for $250,000 after-tax and is expected to be sold for $300,000 after-tax in five years. The unit, which originally cost $480,000 after-tax, is expected to be used five more years and have a market value of $15,000 after-tax after five years. KFC is considering replacing the existing unit with a newer, more efficient one. The new unit will cost $700,000 after-tax and will require an additional $50,000 after-tax for installation. The new unit will also require KFC to increase its investment in initial net working capital by $40,000. The new unit will be depreciated on a straight-line basis over five years to a zero balance. KFC can currently sell the existing unit for $275,000 before-tax. KFC’s marginal tax rate and appropriate discount rate are 20% and 10%, respectively.

If KFC purchases the new unit, annual sales revenues are expected to increase by $100,000 before-tax (due to increased processing capacity), and annual operating costs (exclusive of depreciation) are expected to remain constant at this new level over the five-year life of the project. After five years, the new unit will be completely depreciated and is expected to be sold for $70,000 before-tax.

A. (12 points) What is the initial outlay associated with this project?

B. (6 points) What is the operating cash flow per year?

C. (8 points) What is the terminal cash flow?

D. (4 points) Should this machine be replaced? Support your argument with NPV.

Answer 1

A. Initial Outlay (USD 570,000)

			Year 0
Cost of the new unit	-700000
Cost of installation of new unit	-50000
Sales price of existing unit before tax	275000
Tax of sales price of existing unit	-55000
Increase in net working capital	-40000
Initial Cash outlay		-570000

Answer A

B. Incremental Operating Cash flows every year

Operating Cash flows		Year 1	Year 2	Year 3	Year 4	Year 5
-Increase in annual sales revenues		100000	100000	100000	100000	100000
Change in cost			0	0	0	0	0
Taxes (@20%)			-20000	-20000	-20000	-20000	-20000
Operating Cash Flows		80000	80000	80000	80000	80000

Answer B

C. Terminal Cash Flows

Terminal Cash Flows						Year 5
Sale of new unit (Salvage Value)						70000
Tax on Salvage value (@20%)						-14000
Net Working Capital Recapture						40000
Total Terminal Cash Flows						96000

Answer C

D NPV is negative and hence we shouldnt take up the project. Workings below

Kirksville Foods
				Year 0	Year 1	Year 2	Year 3	Year 4	Year 5
	Cost of the new unit	-700000
	Cost of installation of new unit	-50000
	Sales price of existing unit before tax	275000
	Tax of sales price of existing unit	-55000
	Increase in net working capital	-40000
	Initial Cash outlay		-570000
	Operating Cash flows
	-Increase in annual sales revenues		100000	100000	100000	100000	100000
	Change in cost			0	0	0	0	0
	Taxes (@20%)			-20000	-20000	-20000	-20000	-20000
	Operating Cash Flows		80000	80000	80000	80000	80000
	Terminal Cash Flows
	Sale of new unit (Salvage Value)						70000
	Tax on Salvage value (@20%)						-14000
	Net Working Capital Recapture						40000
	Total Terminal Cash Flows						96000
	Total Cash Flows		-570000	80000	80000	80000	80000	176000
	Discount Rate	10%
			NPV	USD -1,88,298.74

Answer D

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