the lucky seven company is an international clothing manufacturer. its Redmond p
ID: 2480200 • Letter: T
Question
the lucky seven company is an international clothing manufacturer. its Redmond plant will become idle on December 31, 2016. Peter laney, the corporate controller, has been asked to look at three options regarding the plant. a) the plant, which has been fully depreciated for tax purposes, can be sold immediately for $450,000. b)the plant can be leased to the preston corporation, one of lucky seven's suppliers, for four years. under the lease terms, preston would pay lucky seven $110,000 rent per year (payable at year_end) and would grant lucky seven a $20,000 annual discount off the normal price of fabric purchased by lucky seven. preston would lease all of the plant's ownership costs. lucky seven expects to sell this plant for $75,000 at the end of the four year lease. c) the plant could be used for four years to make aoubenir jackets for the olympics. fixed overhead costs before any equipmen t upgrades are estimated to be $10,000 annually for the four-year period. the jackets are expected to sell for $55 each. variable cost per unit is expected to be $42. the following production and sales of jackets are expected: 2017, 9,000 units; 2018, 13,000 units; 2019, 15,000 units; 2020, 5,000 units. in order to manufacture the jackets, some of the plant equipment would need to be upgraded at an immediate cost of $80,000. the equipment would be depresiated using the straight-line depreciation method and zero terminal disposal value over the four years it would be in use. because of the equipment upgrades, lucky seven could sell the plant for $135,000 at the end of four years. no change in working capital would be required. lucky seven treats all cash flows as if they occur at the end of the year, and it uses an after-tax required rate of return of 10%. lucky seven is subject to a 35% tax rate on all income, including capital gains. 1) calculate net present value of each of the options and determine which option lucky seven should select using the NPV criterion. 2)what nonfinancial factors should lucky seven consider before making its choice? (show formulas)
Explanation / Answer
Part 1)
The NPV under all the options is calculated as follows:
Option 1:
__________
Option 2:
The NPV is calculated as follows:
NPV = Cash Flow Year 1/(1+Required Return)^1 + Cash Flow Year 2/(1+Required Return)^2 + Cash Flow Year 3/(1+Required Return)^3 + Cash Flow Year 4/(1+Required Return)^4
Using the EAT values calculated above, we get,
NPV = 84,500/(1+10%)^1 + 84,500/(1+10%)^2 + 84,500/(1+10%)^3 + 133,250/(1+10%)^4 = $301,151
__________
Option 3:
The NPV is calculated as follows:
NPV = Cash Flow Year 0 + Cash Flow Year 1/(1+Required Return)^1 + Cash Flow Year 2/(1+Required Return)^2 + Cash Flow Year 3/(1+Required Return)^3 + Cash Flow Year 4/(1+Required Return)^4
Using the values calculated above, we get,
NPV = -80,000 + 76,550/(1+10%)^1 + 110,350/(1+10%)^2 + 127,250/(1+10%)^3 + (42,750 + 135,000*(1-35%))/(1+10%)^4 = $265,527
__________
Based on the above calculations, Lucky Seven should select Option 2 as it offers the highest NPV.
__________
Part 2)
Nonfinancial factors that Lucky Seven should consider include the following:
Option 1 will provide Lucky Seven with immediate cash flow that can be used for other projects.
With the use of Option 2, Lucky Seven can establish a more reliable and closer relationship with the
supplier. However, it would influence the flexibility (to buy from other suppliers) of Lucky Seven if the quality of the fabric offered by Preston is not of competitive quality.
With Option 3, Lucky Seven has the opportunity to enter a new business. If the new business is
successful, it could be expanded to produce souvenir jackets for other similar events. The
risks that may be associated with the sale of estimated number of jackets should also be taken into account.
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