Question

You have been hired by Amreez Corporation (AC), a manufacturer of Bop a Pop (BaP), a recent fad, to determine whether or not AC should pursue the manufacture of BaP. After a few meetings with key executives, you have collected the following information:a. AC owns a plot of land that it had bought ten years ago for $1.5 million with the intent of using it to set up a waste management plant. However, it has since subcontracted their waste management process. b. Land prices in the area have been increasing at 3.5% per year and are expected to continue to grow at the same rate, and AC’s top brass is not concerned about non-use of the land.c. AC had recently hired a marketing consultant, who was paid $250,000 to analyze the BaP market.d. The marketing consultant had estimated that AC can have annual sales of 60000, 70000, and 30000 units of BaP at a price of $40/piece in the next three years, and then the fad will dissipate.e. If AC decides to manufacture BaP, it will construct a building at a cost of $1,670,000 and install equipment worth $730,000.f.Variable cost of manufacturing per unit will be $4.50, and production will also need additional working capital of $210,000g. Building will be depreciated on a straight line basis to zero in 30 years, land cannot be depreciated, while the equipment will be depreciated on a three year MACRS schedule. h. At the end of 3 years, AC plans to shut down the manufacture of BaP, and sell the equipment for $350,000, and the building and land for $3,500,000.i.Corporate Tax rate is 21%. j.AC requires a minimum return of 13.5% on all its projects. You like to base your results on NPV and IRR. Prepare a report of your analysis for AC.

Answer 1

The cash flows, NPV and IRR are calculated as below :

Operating Cash Flow (OCF) each year = income after tax + depreciation

Book value of equipment after 3 years = $730,000 - cumulative depreciation = $730,000 - $675,907 = $54,903

Sale price of equipment = $350,000

tax on sale of equipment = ($350,000 - $54,903) * 21%

Land was bought 10 years ago for $1.5 million. This price is increasing by 3.5% per year

Price of land 3 years from now = $1.5 million * (1 + 3.5%)¹³ = $2,345,934

Sale price of building and land = $3,500,000

Sale price of building = $3,500,000 - $2,345,934 = $1,154,066

Book value of building after 3 years = $1,670,000 - cumulative depreciation = $1,670,000 - $167,000 = $1,503,000

Tax advantage on Loss on sale of building = ($1,503,000 - $1,154,066) * 21% = $73,276

Terminal year cash flow = Operating Cash flow + Salvage value after tax (building) + salvage value after tax (equipment) + working capital return + return of working capital

NPV is calculated using NPV function in Excel

IRR is calculated using IRR function in Excel

NPV is positive, and IRR is higher than the minimum acceptable rate of return. The project should be accepted