Sales from the contract are forecast at $380,000 each year. Variable costs are e

Question

Sales from the contract are forecast at $380,000 each year. Variable costs are estimated at $250,000 the first year, and Jo believes they will decrease at the rate of $5000 per year, as they become expert in growing the new items in the new greenhouses.

Incremental variable overhead for the new space is expected to be $30,000 per year but when the total overhead is re-allocated (based on square feet under glass) the new production will be charged $45,000 per year.

Upon completion of the 5-year contract, Jo believes she can either obtain another contract from this customer, obtain a similar contract from another grocery chain, use the project’s assets to meet increased demand for herbs from current customers of the original operation, or dispose of the project’s assets. She believes the land can be sold for what was paid for it and each greenhouse is expected to have a market value of $40,000 at the end of the 5-year contract. This decision will be made early enough in the fifth year of the contract to dispose of the project’s assets in that year.

The state tax rate is 11%. Jo uses an after-tax MARR of 12%.

Explanation / Answer

Year 0 Year 1 2 3 4 5 Purchase cost of land -40000 Sales 380000 380000 380000 380000 380000 Less:V.C. 250000 245000 240000 235000 230000 Less:VOH 45000 45000 45000 45000 45000 Income Before tax 85000 90000 95000 100000 105000 Sale proceeds of land 40000 Total cash flow 85000 90000 95000 100000 145000 Less: State tax @ 11% 9350 9900 10450 11000 11550 Net annual Cash flow -40000 75650 80100 84550 89000 93450 PV F @ 12% 1 0.89286 0.79719 0.71178 0.63552 0.56743 PV @ 12% -40000 67544.86 63854.92 60181 56561.28 53026.33 Net present value of the contract 261168.4 ie. 261168

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