You consider a new piece of equipment that will cost $400,000, and will require $20,000 for shipping and installation. NWC will increase immediately by $25,000. The project will last 3 years and the equipment has a 5 year class life. Revenues will increase by $220,000/year, and defect costs will decrease by $220,000/year. Operating costs will increase by $30,000/year. The market value of the equipment after year 3 is $200,000. The cost of capital is 12%; marginal tax rate is 30%. What is the NPV?

1. Your friend Nigel is a management graduate and therefore has little chance of finding a job outside the fast-food industry. Luckily for him, Nigel's rich uncle has left him $20 million in his will. Having been a management student, Nigel partied while you studied. In fact, he took no courses in finance and thus knows nothing about investment. In a drunken stupor, late one Saturday night Nigel watched an interview with the Guru Jack ma. The Guru claims material wealth lies beneath the ground in Melbourne. It is clear from the tone of the interview, the title of the documentary was "An interview with a crackpot," that the interviewer and the "experts" on the show think the Guru is insane. However, Nigel believes in the Guru because his management training taught him to believe in gurus (Peter Drucker, for example). Nigel decides to use his new-found fortune to prove the Guru correct, making himself one of the richest people in Australia in the process! Nigel knows you have superior intellect (otherwise you wouldn't be in Finance) and asks you to work out the details. After some discreet investigation you find the homes and land can be purchased for $15 million. In addition, the local council insist on a $4 million fee for defacing the views from the city. Finally, it costs $1 million to lease the mining equipment. You and Nigel meet with the Guru and after several hours of meditation the Guru provides you with estimated annual after-tax cash-flows. These cash-flows are in millions and are provided to you below in table 2-1. Nigel thinks the cash-flows sound fantastic (compared to a career flipping burgers. Who wouldn't), you however decide to check the numbers using what you have learned in Finance. You believe the project is very risky and therefore in consultation with Westpac Bank Risk Management team decide to use a discount rate of 23%.

1. Should Nigel invest his fortune based on the crackpot's ideas?

2. Would your decision change if you used a discount rate of 18% or 10% ? Support the answer with the NPV and IRR.

              Table 2-1

               Projected Cash Flows

The Daniels Tool & Die Corporation has been in existence for a little over 3 years, and sales have been increasing each year.  A job-order cost system is used.  Factory overhead is applied to jobs based on direct labor hours, utilizing the full absorption costing method.  Overapplied or underapplied overhead is treated as an adjustment to cost of goods sold. The company’s income statements for the last 2 years are presented below:

Daniels Tool & Die Corporation

Year 3-Year 4 Comparative Income Statements

                                                                                                            Year 3               Year 4

Sales                                                                                                    $840,000         $1,015,000

Cost of goods sold:

  Finished goods, 1/1                                                                                  25,000                 18,000

  Cost of goods manufactured                                                                   548,000              657,600

     Total available                                                                                     573,000              675,600

  Finished goods, 12/31                                                                              18,000                 14,000

     Cost of goods sold before overhead adjustment                                   555,000              661,600

  Underapplied factory overhead                                                                36,000                 14,400

     Cost of goods sold                                                                               591,000              676,000

  Gross profit                                                                                           249,000              339,000

  Selling expenses                                                                                      82,000                 95,000

  Administrative expenses                                                                          70,000                 75,000

     Total operating expenses                                                                    152,000              170,000

          Operating income                                                                             97,000               169,000

Daniels Tool & Die Corporation

Inventory Balances

                                                                        1/1/Year 3        12/31/Year 3    12/31/Year 4

  Raw material                                                  22,000             30,000             10,000

  Work-in-process costs                                     40,000             48,000             64,000

  Direct labor hours                                             1,335               1,600               2,100

  Finished goods cost                                         25,000             18,000             14,000

  Direct labor hours                                             1,450               1,050                  820

Daniels used the same predetermined overhead rate in applying overhead to production orders in both Year 3 and Year 4.  The rate was based on the following estimates:

                        Fixed factory overhead                                     $25,000

                        Variable factory overhead                                 155,000

                        Direct labor hours                                              25,000

                        Direct labor costs                                             150,000

In Year 3 and Year 4, actual direct labor hours expended were 20,000 and 23,000, respectively. Raw materials put into production were $292,000 in Year 3 and $370,000 in Year 4.  Actual fixed overhead was $37,400 for Year 4 and $42,300 for Year 3, and the planned direct labor rate was the direct labor rate achieved.

For both years, all the reported administrative costs were fixed, while the variable portion of the reporting selling expenses result from a commission of 5% of sales revenue.

Questions

For the year ended December 31, Year 4, prepare a revised income statement utilizing the variable (direct) costing method.  Be sure to include contribution margin.

Prepare a numerical reconciliation of the difference in operating income between Daniels’ Year 4 income statement prepared on the basis of absorption costing and the revised Year 4 income statement prepared on the basis of variable costing.

(Required) What is the present value of the payment stream discounted at 5% annually: $1000 at the end of year 1, -$2000 at the end of year 2, and $3000 at the end of year 3? Also calculate future value of the cash flows at the end of year 3. Financial calculator not allowed for this question. Show all work!

Donald takes out a loan to be repaid with annual payments of $500 at the end of each year for 2n years. The annual effective interest rate is 4.94%. The sum of the interest paid in year 1 plus the interest paid in year n + 1 is equal to $720. Calculate the amount of interest paid in year 10.

Short answer question. The cash flow associated with a strip mining operation is expected to be £200,000 in year 1, £180,000 in year 2 and amounts decreasing by £20,000 per year to year 8 when it is assumed the mine will be exhausted. What is the present value of the mine? Assume interest is 7%. Show your working.

Leisure Manufacturing, Inc. is a producer of grills. Its current line of grills are selling excellently. However, in order to cope with the foreseeable competition from other similar products, LM spent $6,200,000 to develop a new line of expert grills (new model development cost). The grill measurses 55"W x 25"D x 48"H and weighs 60 pounds on two wheels and two stable legs. It has 4 stainless steel tube burners providing a total of 48,000 BTU on a push and turn integrated ignition system using liquid propane gas. It is versifuel compatible. That means it can be converted to use nautral gas with the implementation of the optional versifuel kit. The primary cooking area is 480 sq. inches enabling a cooking capacity of 28 burgers at the same time whereas the warming rack area is 180 sq. inches. In addition to the black stainless steel control panel and two black powder-coated side shelves on the left, the grill has a black stainless steel 12,000-BTU side burner for the preparation of sauces and side dishes on the right.  The grill includes a porcelain-coated cast iron cooking grid panel and a black porcelain-coated flame tamer for each individual burner. The warming rack is built with porcelain-coated steel. The lid is made of stainless steel with aluminized steel liner and black steel endcaps. The oval temperature gauge is located in the center of the lid. The same porcelain-coated steel is used to build the bottom bowl. Its porcelain heat plates are designed to reduce flare ups. The company had also spent a further $1,000,000 to study the marketability of this new line of expert grill model (marketability studying cost).

LM is able to produce the expert grills at a variable cost of $60 each. The total fixed costs for the operation are expected to be $10,000,000 per year. LM expects to sell 3,500,000 units, 4,300,000 units, 3,200,000 units, 1,800,000 units and 1,200,000 units of the new grill model per year over the next five years respectively. The new expert grills will be selling at a price of $150 each. To launch this new line of production, LM needs to invest $35,000,000 in equipment which will be depreciated on a seven-year MACRS schedule. The value of the used equipment is expected to be worth $3,800,000 as at the end of the 5 year project life.

LM is planning to stop producing the existing grill model entirely in two years. Should LM not introduce the expert grill, sales per year of the existing grill model will be 1,800,000 units and 1,400,000 units for the next two years respectively. The existing model can be produced at variable costs of $50 each and total fixed costs of $7,500,000 per year. The existing grill model are selling for $115 each. If LM produces the expert grill model, sales of existing model will be eroded by 1,080,000 units for next year and 1,190,000 units for the year after next. In addition, to promote sales of the existing model alongside with the expert grill model, LM has to reduce the price of the existing model to $85 each. Net working capital for the expert grill project will be 20 percent of sales and will vary with the occurrence of the cash flows. As such, there will be no initial NWC required. The first change in NWC is expected to occur in year 1 according to the sales of the year. LM is currently in the tax bracket of 35 percent and it requires a 20 percent returns on all of its projects. The firm also requires a payback of 3 years for all projects.

You have just been hired by LM as a financial consultant to advise them on this expert grill project. You are expected to provide answers to the following questions to their management by their next meeting which is scheduled sometime next month.   

What is/are the sunk cost(s) for this expert grill project? Briefly explain. You have to tell what sunk cost is and the amount of the total sunk cost(s). In addition, you have to advise LM on how to handle such cost(s).

What are the cash flows of the project for each year?

What is the payback period of the project?

What is the PI (profitability index) of the project?  

What is the IRR (internal rate of return) of the project?

What is the NPV (net present value) of the project?

Should the project be accepted based on Payback, PI, IRR and NPV? Briefly explain.

Estimation of sunk costs

Provide below the amounts of the sunk costs you identified from the case description above.

1st sunk cost: $     being        cost  (Use exactly the same wording as in the case background information.)

2nd sunk cost: $     being     cost  (Use exactly the same wording as in the case background information.)

Total sunk costs = $  

Net Sales Estimation: Use the formula stated below to calculate the net sales.

Year t Net Sales

=Unit sales of new model for Year t × Price of new model

– Reduction in unit sales of existing model for Year t × Current price of existing model

– [(Unit sales of existing model for Year t if new model project is not launched – Reduction in unit sales of existing model if new model project is launched) × (Current price of existing model – Reduced price of existing model)]

Year 1 Net Sales

=  × $   –  × $  

     – (   –  ) × ($   – $   )

= $           

Year 2 Net Sales

=  × $   –  × $  

     – (   –  ) × ($   – $   )

= $  

Year 3 Net Sales = $  

Year 4 Net Sales = $  

Year 5 Net Sales = $  

Variable Cost Estimation: Use the formula stated below to calculate the variable costs.

Year t Variable costs

=   Unit sales of new model for Year t × Variable cost per unit of new model

   – Reduction in unit sales of existing model for Year t × Variable cost per unit of existing model

Year 1 Variable costs

=   × $   –  × $  

=$  

Year 2 Variable costs

=   × $   –  × $  

=$     

Year 3 Variable costs =$     

Year 4 Variable costs =$     

Year 5 Variable costs =$     

Depreciation Estimation: Use the formula stated below to calculate the depreciation expenses.

Depreciation of Year t   = Cost of equipment × MACRS percentage for Year t

[For all MACRS percentages in this part, enter as a decimal number with 4 decimal places.]     

Depreciation of Year 1 = $      ×     =$    

Depreciation of Year 2 = $      ×     =$       

Depreciation of Year 3 = $      ×     =$     

Depreciation of Year 4 = $      ×     =$  

Depreciation of Year 5 = $     ×    =$  

Net Working Capital Estimation: Use the formula stated below to calculate the net working capital requirements.

NWC for Year t   = NWC Required Percentage × Net sales of Year t

[For the NWC required percentage in this part, enter as a decimal number with 2 decimal places.]       

NWC for Year 1   =     × $      =$  

NWC for Year 2   =     × $      =$  

NWC for Year 3   =     × $      =$  

NWC for Year 4   =     × $      =$  

NWC for Year 5   = $  

CASH FLOW ESTIMATION: Complete the following table below.

Estimation of total Year 5 cash flow: Provide your responses to the following.

At the end of the project's 5-year life,

Accumulated depreciation of equipment = $  

Book value of equipment = $  

Market value of equipment = $  

Tax associated with sale of equipment = $    [Enter as a positive number if tax liability or as a negative number if tax credit.]

CF on sale of equipment = $  

Total Year 5 cash flow = $     

Hint : Net CF (Net cash flow) = OCF (Operating cash flow) + NWC CF (Net working capital cash flow)

Year 1 through Year 4 cash flow = Net CF of the individual years.

Year 5 cash flow = Net CF of Year 5 + CF on sales of equipment.  

Evaluation of Project: Fill out the following tables.

(Do not round your calculations. Round your answers below to the number of decimal places specified.)