A firm is re-evaluating one of its current product lines to determine whether it

Question

A firm is re-evaluating one of its current product lines to determine whether it will continue to be profitable or whether it should be dropped. Net operating revenues (sales minus all operating costs) are estimated to be $4,000 per year for each of the next 6 years, after which time such revenues will drop to $2,000 per year. It is estimated that the product line has a useful life of 12 years, that is, after year 12 no further revenues are anticipated. If the product line were shut down, it would entail expenses of $5,000. On the other hand, machinery used in the production could be sold for $15,000. This machinery is part of an asset class for which the applicable rate for CCA is 30 percent. The class is not left empty by the sale of the machinery. The floor space that is vacated by the shutdown could be leased out at $1,000 per year. The firm%u2019s tax rate is 40 percent, and the appropriate discount rate is 16 percent.

Question: Based on a net present-value analysis, should the firm continue operations or close down the product line?

Explanation / Answer

If Product Line is not Discontinued Year Net Operating Revenue Tax @ 40% PAT PVF @ 16% PV 1 4000 1600 2400 0.862 2068.8 2 4000 1600 2400 0.743 1783.2 3 4000 1600 2400 0.641 1538.4 4 4000 1600 2400 0.552 1324.8 5 4000 1600 2400 0.476 1142.4 6 4000 1600 2400 0.41 984 7 2000 800 1200 0.354 424.8 8 2000 800 1200 0.305 366 9 2000 800 1200 0.263 315.6 10 2000 800 1200 0.227 272.4 11 2000 800 1200 0.195 234 12 2000 800 1200 0.168 201.6 5.196 10656 If Product is Discontinued PV of cash outflow = $5000 ( Shut down expenses) PV of cash inflow = $15000+ ($1000*cumulative PV @16% upto 12th year) hence PV= $15000 +$5196=$20196 NPV = $20196-$5000=$15196 Hence Product line should be shut down as it results into extra revenue of $ 4540 (15196-10656)

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