Question

A company that manufactures recreational pedal boats has approached Mike Cichanowski to ask if he would be interested in using Current Designs’ rotomold expertise and equipment to produce some of the pedal boat components. Mike is intrigued by the idea and thinks it would be an interesting way of complementing the present product line.

One of Mike"s hesitations about the proposal is that the pedal boats are a different shape than the kayaks that Current Designs produces. As a result, the company would need to buy an additional rotomold oven in order to produce the pedal boat components. This project clearly involves risks, and Mike wants to make sure that the returns justify the risks. In this case, since this is a new venture, Mike thinks that a 15% discount rate is appropriate to use to evaluate the project.

As an intern at Current Designs, Mike has asked you to prepare an initial evaluation of this proposal. To aid in your analysis, he has provided the following information and assumptions.

1.The new rotomold oven will have a cost of $256,000, a salvage value of $0, and an 8-year useful life. Straight-line depreciation will be used.

2.The projected revenues, costs, and results for each of the 8 years of this project are as follows.

Sales revenue Less:		$220,000
Manufacturing costs	$140,000
Depreciation	32,000
Shipping and administrative costs	22,000	194,000
Income before income taxes		26,000
Income tax expense		10,800
Net income		$15,200

Instructions

(a)Compute the annual rate of return. (Round to two decimal places.)

(b)Compute the payback period. (Round to two decimal places.)

(c)Compute the NPV using a discount rate of 9%. (Round to nearest dollar.) Should the proposal be accepted using this discount rate?

(d)Compute the NPV using a discount rate of 15%. (Round to nearest dollar.) Should the proposal be accepted using this discount rate?

Answer 1

a) Annual rate of return : Net Income / Average investment

              = 15200 / 256000

              = .0594 or 5.94%

b)Annual cash Flow : Net Income + Depreciation (non cash)

                = 15200 +32000

                = $ 47200

Payback period : Initial cost / Annual cash flow

       = 256000 /47200

          = 5.42 years

c) Present value of annual cash Flow : [PVA 9%,8 * Annual cash Flow )

         = [5.53482* 47200]

          = 261,243.50

NPV =Present value -initial cost

      = 261,243.50 - 256000

        = $ 5243.50   [rounded to 5244 ]

since NPV is positive ,proposal should be accepted .

d)Present value : [PVA 15%,8*Annual cash flow]

          =[ 4.48732*47200]

          = 211801.50

NPV : 211801 .50 - 256000

    = $ -44198

Since NPV is negative ,proposal should not be accepted.

**Find present value annuity factor from annuity table at 9% and15% at 8 periods.