Use the following information to answer questions 31-40. Answer these questions

Question

Use the following information to answer questions 31-40. Answer these questions directly on the exam and place a box around your final answer. Your friend, John, is the owner of a small manufacturing company that is experiencing minimal sales growth the last three years. Seven years ago, his company was experiencing double digit sales growth and he invested $500,000 in an additional production line. However, the economy slowed and this line has sat idle. John has been approached by a potential new customer that needs his product, but only for the next five years. The contract will be enough volume to where he will need to utilize the idle production line. He will also need to acquire a new piece of equipment for $180,000. This piece of equipment will replace an existing piece of equipment that was just recently purchased for $45,000. However, John will be able to trade it in for $20,000. The new piece of equipment will have no salvage value after the 5 year period. Even though this contract will only be for 5 years, John is excited about the opportunity because he can now recapture part of his investment in the second production line. John knows he will have incremental costs (variable costs) specific to the new investment and he also plan on allocating a portion of the company’s overhead on a pro rata basis (he has multiple production lines, not just two). His current allocation is $2.00 per unit. In addition to the overhead allocation, he plans on allocating an additional $3.00 per unit to account for the use of the idle production line. John is now trying to determine the merit of this contract and the additional investment. He has enlisted your help in analyzing all of the cash flows. He has split them into two parts:

initial net investment and net income over the 5 years of the contract.

Initial Investment

Idle Production Line ($500,000)

Original Equipment Cost ($45,000)

New Equipment Cost ($180,000)

Trade-In Value of Original Equipment $20,000

John also prepared a pro forma income statement for the five years of the contract.

Year 1 Year 2 Year 3 Year 4 Year 5

Units 10,000 12,000 14,400 17,280 20,736

Sales $650,000 $780,000 $936,000 $1,123,200 $1,347,840

COGS $422,500 $507,000 $608,400 $730,080 $876,096

Gross Profit $227,500 $273,000 $327,600 $393,120 $471,744

Operating Expenses Variable Costs $100,000 $110,000 $120,000 $130,000 $140,000

Overhead Allocation $20,000 $24,000 $28,800 $34,560 $41,472

Idle Production Line Cost Allocation $30,000 $36,000 $43,200 $51,840 $62,208

Total Expenses $150,000 $170,000 $192,000 $216,400 $243,680

Earnings Before Taxes $77,500 $103,000 $135,600 $176,720 $228,064

Income Taxes $27,125 $36,050 $47,460 $61,852 $79,822

Net Income $50,375 $66,950 $88,140 $114,868 $148,242

Based on a cost of capital of 12% and what you know about analyzing relevant cash flows of an investment decision, John has asked you to review his work and answer the following questions: (Hint: You must recalculate Net Income using relevant cash flows only. IGNORE DEPRECIATION EXPENSE )

31. What is the present value of the initial investment needed to fulfill this contract (Net Cash Outflows)?

32. What is the present value of the Net Cash Inflows for Year 1?

33. What is the present value of the Net Cash Inflows for Year 2?

34. What is the present value of the Net Cash Inflows for Year 3?

35. What is the present value of the Net Cash Inflows for Year 4?

36. What is the present value of the Net Cash Inflows for Year 5?

37. What is the Net Present Value of the investment opportunity?

38. What is the approximate payback period of the investment opportunity?

39. What is the Cost Benefit Ratio of the investment?

40. What is the Internal Rate of Return for the investment opportunity? (If necessary, utilize average net income for your payment stream)

Explanation / Answer

31. Calculation of present value of initial cash outflow

32. Calculation of present value of Cash inflows

P.V. of cash inflows = 318209

33. As calculated above P.V of net cash inflow for year 2 is $53359

34. As calculated above P.V of net cash inflow for year 3 is $62756

35. As calculated above P.V of net cash inflow for year 4 is $73056

36. As calculated above P.V of net cash inflow for year 5 is $84053

37. NPV = P.V 0f cash outflow - P.V. of cash inflows

= $660000 - $318209

= $341791

Particulars Amount Investment in new production line $500000 Investment in new equipment $180000 Sale value of old equipment ($20000) Present value of cash outflow $660000

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