Question

Case Study: Alexander & Sons

Alexander & Sons Company is currently considering the purchase of equipment that produces mugs.

• The equipment needed would cost $3 million, with a disposal value of $400,000.
• The equipment would be able to produce 55 million mugs over its 5-year life.

The company has estimated that approximately 11 million mugs would be sold for each of the next 5 years, at the following prices:

• $1.00 for year 1 and 2
• $1.20 for year 3 and 4
• $1.25 for year 5

The company would hire seven new employees.

• These seven individuals would be full-time employees.
• Each will work 2,000 hours per year and earn:
  • $31 per hour in the first 3 years.
  • $32 per hour in year 4 and 5.

All employees would also receive annual benefits making up 20 percent of wages, in addition to an annual $10,000 cost for health benefits for each employee.

It is estimated that:

• The raw materials needed will cost 0.50 per mug.
• Other variable costs would be 0.20 per mug.
• No additional fixed costs would be incurred if this project is accepted.

The company's discount rate is 10 percent, and the current tax rate of 35 percent is anticipated to remain unchanged. The company uses the straight-line method for depreciation.

Case Study Questions

Based on the above information, calculate the following items:

• Annual net cash flows over the expected life of the equipment
• Payback period
• Net present value
• The accounting rate of return

Answer 1

The annual net cash flows are calculated as below :

employee benefits in each year = (employee wages * 20%) + $10,000

depreciation per year = equipment cost / 5

net cash from sale of equipment = sale price * (1 - tax rate) = 400,000 * (1 - 35%) = $260,000

net cash flow in each year = income after taxes + depreciation (non-cash expense)

payback period is the time taken the by the net cash flows to recover the initial investment. The initial investment is $3 million. Net cash flow in year 1 and year 2 is $2,009,980. $3 million - $2,009,980 = $990,020. In year 2, time taken to reach $3 million in total cumulative cash flows = $990,020 / $2,009,980 = 0.49 years. Payback period for the project is 1.49 years

the net cash flow of each year is discounted back to the present using the discount rate of 10%. The sum of all these discounted cash flows is the NPV of the project

NPV of the project is $7,927,592

accounting rate of return = net profit / net investment

the average net profit over 5 years is calculated as below :

average net profit = $2,335,112. average investment = $3 million

ARR = $2,335,112 / $3 million = 77.84%