Rob Roy Corporation has been using its present facilities at its annual full cap

Question

Rob Roy Corporation has been using its present facilities at its annual full capacity of 10,000 units for the last 3 years. Sti the company is unable to keep pace with continuing demand for the product that is estimated to be 25,000 units annual This demand level is expected to continue for at least another 4 years. To expand manufacturing capacity and take advantage of the demand, Rob Roy must acquire equipment costing $1,000,000. The equipment will double the current production quantity This equipment has a useful life of 10 years and can be sold for $200,000 at the end of year 4 or $30,000 at the end of year 10. Analysis of current operating data provides the following information: Sales price Variable costs: Per Unit $232 Manufacturing Marketing s 97 10 s 45 $107 Fixed costs: Manufacturing 25177 s 55 Pretax operating income The fixed costs include depreciation expense of the current equipment. The new equipment will not change variable costs, but the firm will incur additional fixed manufacturing costs (excluding depreciation on the new machine) of $250,000 annually. The firm needs to spend an additional $200,000 in fixed marketing costs per year for additional sales Rob Roy is in the 35% tax bracket Management has set a minimum rate of return of 150% after-tax for all capital investments. Assume, for simplicity, that MACRS depreciation rules do not apply

Explanation / Answer

Present Value (PV) of Cash Flow: (Cash Flow)/((1+i)^N) i=Discount Rate=Minimumrate of return=15%=0.15 N=Year of Cash Flow I Initial Cash Flow ($1,000,000) CALCULATION OF ANNUAL OPERATING CASH FLOW A Additional Production Quantity 10000 B Unit Contribution $125 (232-107) C=A*B Annual Contribution $1,250,000 D Additional fixed manufacturing cost $250,000 E Additional fixed marketing cost $200,000 F=C-D-E Before tax operating Cash flow $800,000 G=F*(1-0.35) After tax operating cash flow $520,000 CALCULATION OF DEPRECATION TAX SHIELD H Depreciable asset value $1,000,000 J Usefullife in years 10 K Salvage Value $30,000 L=(H-K)/J Annual Depreciation $            97,000 M=L*0.35 Annual depreciation tax shield $            33,950 P=G+M After tax annual cash inflow $553,950 CALCULATION OF TERMINALCASH FLOW Q Salvage Value after 4 years $200,000 R=H-(4*L) Bookvalue after 4 years $          612,000 S=R-Q Loss on salvage $          412,000 T=S*0.35 Tax savings due toloss $          144,200 U=Q+T Terminalcash inflow $344,200 V Present Value of Cashinflows $1,778,313 (Using PV function of excelwithRate=15%, Nper=4, Pmt=-553950, Fv=-344200) NPV=V+I Net Present value $778,313 YEARWISE CASH FLOWS ARE GIVEN BELOW: N Year 0 1 2 3 4 CF Cash flow ($1,000,000) $553,950 $553,950 $553,950 $898,150 SUM PV=CF/(1.15^N) Present Value of Cash Flows ($1,000,000) $         481,696 $ 418,866 $   364,231 $     513,520 $778,313 842488.7063 732598.88 637042.5 898150 $3,110,280 NPV=Sum of PV Net Present Value $778,313 InternalRate of return (IRR) 46.99% (using IRR fnction of excel over the cash flow) MIRR 32.8% (using MIRR function of excel over the cash flow)

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