Question

Please show how you got all calculations If McCormick & Company decides to purchase the new factory in Largo, they need to consider relevent after-tax cash flow. McCormick & Company estimated their potential first-year sales revenue at $780,000, expenses at $225,000, and depreciation expense at $150,000. McCormick's marginal tax rate is 40 percent (21 percent federal and 19 percent state combined). What is first-year relative cash flow? 3. The estimated relevent annual expected cash flows (C1) associated with the puchase of the new factory in Largo are as follows: Year C1 PV(C1) 1 ? ? 2 $291,000 $202,083 3 $191,000 $110,532 4 $306,000 $147,569 5 $424,000 $170,396 In Year 3, the estimated relevent annual expected cash flows represents funds used to pay operating expenses for subsequent years. All estimated relevent annual expected cash flows include a risk premium of 13 percent, which has already been applied to the cash flows above. Solve for cash flow for Year 1 based on your answer in Question 2. Then, solve for present value (PV) for Year 1. What is the total of present value for all five years? Should the factory be purchased? Why or why not?

Answer 1

Part 1 or Question 2)

The first-year relative cash flow is determined as below:

First-Year Relative Cash Flow = (Sales Revenue - Expenses - Depreciation Expense)*(1-Tax Rate) + Depreciation Expense

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Here, Sales Revenue = $780,000, Expenses = $225,000, Depreciation Expense = $150,000 and Tax Rate = 40% (21% + 19%)

Substituting these values in the above formula, we get,

First-Year Relative Cash Flow = (780,000 - 225,000 - 150,000)*(1-40%) + 150,000 = $393,000

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Part 2 or Question 3)

Step 1: Calculate Cost of Capital

The cost of capital can be calculated with the use of equation given below:

Present Value of Cash Flow of Year 2 = Cash Flow Year 2/(1+Cost of Capital)^2

Substituting values in the above formula, we get,

202,083 = 291,000/(1+Cost of Capital)^2

(1+Cost of Capital)^2 = 291,000/202,083

Solving further, we get,

Cost of Capital = (291,000/202,083)^(1/2) - 1 = 20%

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Step 2: Calculate Present Value for Year 1 and Total Present Value for all 5 Years

The present value for year 1 and total present value for all years is determined as below:

Present Value for Year 1 = Cash Flow for Year 1/(1+Cost of Capital)^1 = 393,000/(1+20%)^1 = $327,500

Total Present Value for all 5 Years = Present Value for Year 1 + Present Value for Year 2 + Present Value for Year 3 + Present Value for Year 4 + Present Value for Year 5 = 327,500 + 202,083 + 110,532 + 147,569 + 170,396 = $958,080

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Decision as to Whether Factory Should be Purchased or Not:

The decision as to whether factory should be purchased or not cannot be taken as we have not been provided with the cost of factory in the question. However, if the total present value of all 5 years is greater than the cost of factory, the factory should be purchased and if the total present value of all 5 years is less than the cost of factory, the factory should not be purchased.