\"All of the engineering studies say that tar sand is excellent for use in road
ID: 2475959 • Letter: #
Question
"All of the engineering studies say that tar sand is excellent for use in road construction," said Holly Edwards, chief engineer for Dieter Mining Company. "With road construction projected to be at peak levels over the next 10 years, now is the time for us to extract and sell the tar sand off of tract 370 in the southern part of the state."
"I'm not so sure," replied Tom Collins, the vice president. "Prices are really soft for tar sand. The best we can hope to get is $7 a ton, and the accounting people say it will cost us at least $3 a ton for utilities, supplies, and selling expenses. That doesn't leave much in the way of contribution margin."
"I know we won't get much per ton," replied Holly, "but our studies show that we have 1,735,000 tons of tar sand in the area. I figure we can extract 90,000, 145,000, and 240,000 tons the first three years, respectively, and then the remainder evenly over the next seven years. Even at only $7 a ton, that'll bring a lot of cash flow into the company."
"But you're forgetting that we have other costs, too," said Tom. "Fixed costs for salaries, insurance, and so forth, directly associated with the tar sand project would be $450,000 a year. Besides that, we would have to pay out an additional $250,000 at the end of the project for filling and leveling the land. You know how tough those environmental people can get if things don't look right. And all of this doesn't even consider the $800,000 cost of special equipment that we would need or the $75,000 we would have to put up for working capital to carry inventories and accounts receivable. I'm uneasy about the whole idea."
"You've got to look at the big picture, Tom. You'll get the working capital back in 10 years when the project is completed. In addition, we can depreciate that equipment and save a bundle in taxes at our 30% tax rate. Besides that, since the equipment would have a 12-year useful life, it would still have some use left when the project was completed. I'm sure we could sell it to someone for at least 5% of its original cost."
"All of that sounds fine, Holly, but I'll still bet the project won't provide the 18% after-tax return we require. Let's give all this to accounting and have them do a present value analysis for us."
1. Compute the before-tax net cash receipts each year from the extraction and sale of the tar sand. (Do not include the cost of filling and leveling the land in this computation.)
2. Using the data from (1) above and other data from the problem as needed, prepare a net present value analysis to determine whether the company should purchase the equipment and extract the tar sand. Round all dollar amounts to the nearest whole dollar. You may assume that the company as a whole will have a positive taxable income in every year so that a tax benefit would be realized from any operating losses associated with the tar sand project. Also assume that the special equipment belongs in the MACRS seven-year property class.
Explanation / Answer
Selling Price $ 7 initial cost $ 800,000 Variable Cost $ 3 NWC $ 75,000 Contribution $ 4 Year Contribution per ton Units extracted Contribution Fixed Cost Net Income (Loss)Before Tax Net Cash receipt Macrs Rates Used-Half Year Convention amount of SE Depreciation 1 4 90000 360000 450000 -90000 14.29% 800000 114320 2 4 145000 580000 450000 130000 24.49% 800000 195920 3 4 240000 960000 450000 510000 17.49% 800000 139920 4 4 180000 720000 450000 270000 12.49% 800000 99920 5 4 180000 720000 450000 270000 8.93% 800000 71440 6 4 180000 720000 450000 270000 8.92% 800000 71360 7 4 180000 720000 450000 270000 8.93% 800000 71440 8 4 180000 720000 450000 270000 4.46% 800000 35680 9 4 180000 720000 450000 270000 10 4 180000 720000 450000 270000 Year Contribution per ton Units extracted Contribution Fixed Cost Depreciation Net Income (Loss) Tax @ 30% Income After Tax Add Back Depreciation(OCF) Cash Inflows 1 4 90000 360000 450000 114320 -204320 -61296 -143024 -28704 -28704 2 4 145000 580000 450000 195920 -65920 -19776 -46144 149776 149776 3 4 240000 960000 450000 139920 370080 111024 259056 398976 398976 4 4 180000 720000 450000 99920 170080 51024 119056 218976 218976 5 4 180000 720000 450000 71440 198560 59568 138992 210432 210432 6 4 180000 720000 450000 71360 198640 59592 139048 210408 210408 7 4 180000 720000 450000 71440 198560 59568 138992 210432 210432 8 4 180000 720000 450000 35680 234320 70296 164024 199704 199704 9 4 180000 720000 450000 270000 81000 189000 189000 189000 10 4 180000 720000 700000 20000 6000 14000 14000 10 Plant Sale Value 40000 12000 28000 28000 10 NWC Recovery 75000 117000 Year Cash fows PVF @ 18% PresentValue 0 -800000 1 -800000 0 -75000 1 -75000 1 -28704 0.8474576 -24325.4237 2 149776 0.7181844 107566.7912 3 398976 0.6086309 242829.1111 4 218976 0.5157889 112945.3847 5 210432 0.4371092 91981.76659 6 210408 0.3704315 77941.7593 7 210432 0.313925 66059.87259 8 199704 0.2660382 53128.88545 9 189000 0.2254561 42611.19741 10 117000 0.1910645 22354.54263 NPV -81906.1128 Remarks project results in negative NPV and should not be taken
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