1 answer

You must analyze a potential new product --- a caulking compound that Korry Materials’ R&D people...

Question:

You must analyze a potential new product --- a caulking compound that Korry Materials’ R&D people developed for use in the residential construction industry. Korry’s marketing manager thinks they can sell 115,000 tubes per year at a price of $3.25 each for 3 years, after which the product will be obsolete. The required equipment would cost $125,000, plus another $25,000 for shipping and installation. Current assets (receivables and inventories) would increase by $35,000, while current liabilities (accounts payables and accruals) would rise by $15,000. Variable costs would be 60 percent of sales revenue, fixed costs (exclusive of depreciation) would be $70,000 per year, and the fixed assets would be depreciated under MACRS with a 3-year life. When production ceases after 3 years, the equipment should have a market value of $15,000. Korry’s tax rate is 40 percent, and it uses a 10 percent WACC for average risk projects.

The R&D costs for the new product were $30,000, and those costs were incurred and expensed for tax purposes last year. If Korry Materials accepts the new project it will result in an annual loss of revenues on an existing product of $5,000.

Find the required year 0 investment, the annual after-tax operating cash flows, and the terminal year cash flow. Assuming the project is of average risk, would you recommend accepting the project. Justify your answer.


Answers

ANSWER:-

YEAR 0 INVESTMENT:
Cost of equipment 125000
Shipping and installation 25000
Installed cost of equipment 150000
Add: Increase in NWC [35000-15000] 20000
Year 0 investment 170000
ANNUAL AFTER TAX CASH FLOW: 0 1 2 3
Sales revenue (115000*3.25) 373750 373750 373750
Variable costs (60% of sales revenue) 224250 224250 224250
Fixed costs other than depreciation 70000 70000 70000
Depreciation 49995 66675 22215
Loss of revenue on existing product 5000 5000 5000
Incremental NOI 24505 7825 52285
Tax at 40% 9802 3130 20914
NOPAT 14703 4695 31371
Add: Depreciation 49995 66675 22215
ANNUAL AFTER TAX CASH FLOW: 64698 71370 53586
Capital expenditure (125000+25000) 150000
Increase in NWC (35000-15000) 20000 -20000
After tax salvage value [15000-(15000-11115)*40%] 13446
FCF -170000 64698 71370 87032
PVIF at 10% [PVIF = 1/1.1^n] 1 0.90909 0.82645 0.75131
PV at 10% -170000 58816 58983 65388
NPV 13188
DECISION:
As the NPV is positive, the investment in the project is recommended.
TERMINAL NON OPERATING CASH FLOWS:
Release of NWC 20000
After tax salvage value [15000-(15000-11115)*40%] 13446
Terminal non operating cash inflow 33446
.

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