Question

I am attempting to calculate the annual net cash flow for this problem and cannot figure out how to solve it.

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

Annual depreciation = $ ( 3,000,000 - 400,000 ) / 5 = $ 520,000.

Computation of Cost of Goods Sold:

	1	2	3	4	5
Direct Materials	$ 5,500,000	$ 5,500,000	$ 5,500,000	$ 5,500,000	$ 5,500,000
Direct Labor	590,800	590,800	590,800	607,600	607,600
Other Variable Costs	2,200,000	2,200,000	2,200,000	2,200,000	2,200,000
Total	$ 8,290,800	$ 8,290,800	$ 8,290,800	$ 8,307,600	$ 8,307,600

Computation of Annual Net Cash Flows:

	1	2	3	4	5
Sales	11,000,000	11,000,000	13,200,000	13,200,000	13,750,000
Less: Cost of Goods Sold	8,290,800	8,290,800	8,290,800	8,307,600	8,307,600
EBITDA	2,709,200	2,709,200	4,909,200	4,892,400	5,442,400
Annual Depreciation	520,000	520,000	520,000	520,000	520,000
Salvage Value of Equipment	0	0	0	0	400,000
Net Cash Flow [ EBITDA x ( 1 - t ) + Depreciation x t ]	$ 1,942,980	$ 1,942,980	$ 3,372,980	$ 3,362,060	$ 4,119,560

Payback Period:

	1	2	3	4	5
Annual Net Cash Flow	$ 1,942,980	$ 1,942,980	$ 3,372,980
Cumulative Net Cash Flows	1,942,980	3,885,960

Payback period = 1 year + $ ( 3,000,000 - 1,942,980) / $ ( 3,885,960 - 1,942,980) = 1 year + $ 1,057,020 / $ 1,942,980 = 1.54 years.

Net Present Value:

	0	1	2	3	4	5
Cash Flows	(3,000,000)	1,942,980	1,942,980	3,372,980	3,362,060	4,119,560
PV factor at 10 %	1.0000	0.90909	0.82645	0.75131	0.68301	0.62092
Present Values	(3,000,000)	1,766,344	1,605,776	2,534,154	2,296,321	2,557,917
Net Present Value	$ 7,760,512