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PROBLEM 9-12
PROBLEM 9-12. Comprehensive Capital Budgeting Problem [LO 1, 3] Van Doren Corporation is considering producing a new temperature regulator called Digidial. Marketing data indicate that the company will be able to sell 45,000 units per year at $30. The product will be produced in a section of an existing factory that is currently not in use. To produce Digidial, Van Doren must buy a machine that costs $500,000. The machine has an expected life of 6 years and will have an ending residual value of $15,000. Van Doren will depreciate the machine over 6 years using the straight-line method for both tax and financial reporting purposes. In addition to the cost of the machine, the company will incur incremental manufacturing costs of $370,000 for component parts, $425,000 for direct labor, and $200,000 of miscellaneous costs. Also, the company plans to spend $150,000 annually to advertise Digidial. Van Doren has a tax rate of 40 percent, and the company's required rate of return is 15 percent. REQUIRED a. Compute the net present value. b. Compute the payback period. c. Compute the accounting rate of return. d. Should Van Doren make the investment required to produce Digidial?
Expert Solution
Ans.A. Net Present value = Present value of all cash inflows – Present value of all cash outflows
|
Year 0 |
Year 1 |
Year 2 |
Year 3 |
Year 4 |
Year 5 |
Year 6 |
|
|
Initial cost of machine |
$500,000 |
||||||
|
Annual sales (45,000 units * $30) |
$1,350,000 |
$1,350,000 |
$1,350,000 |
$1,350,000 |
$1,350,000 |
$1,350,000 |
|
|
Less: Manufacturing costs for component parts |
$370,000 |
$370,000 |
$370,000 |
$370,000 |
$370,000 |
$370,000 |
|
|
Less: Direct labor cost |
$425,000 |
$425,000 |
$425,000 |
$425,000 |
$425,000 |
$425,000 |
|
|
Less: Miscellaneous costs |
$200,000 |
$200,000 |
$200,000 |
$200,000 |
$200,000 |
$200,000 |
|
|
Less: Advertising costs |
$150,000 |
$150,000 |
$150,000 |
$150,000 |
$150,000 |
$150,000 |
|
|
Profit before depreciation and tax |
$205,000 |
$205,000 |
$205,000 |
$205,000 |
$205,000 |
$205,000 |
|
|
Less: Depreciation |
$80,833.33 |
$80,833.33 |
$80,833.33 |
$80,833.33 |
$80,833.33 |
$80,833.33 |
|
|
Profit before tax |
$124,166.67 |
$124,166.67 |
$124,166.67 |
$124,166.67 |
$124,166.67 |
$124,166.67 |
|
|
Less: Tax @ 40% |
$49,666.67 |
$49,666.67 |
$49,666.67 |
$49,666.67 |
$49,666.67 |
$49,666.67 |
|
|
Profit after tax |
$74,500 |
$74,500 |
$74,500 |
$74,500 |
$74,500 |
$74,500 |
|
|
Add back : Depreciation |
$80,833.33 |
$80,833.33 |
$80,833.33 |
$80,833.33 |
$80,833.33 |
$80,833.33 |
|
|
Cash flows after-tax |
$155,333.33 |
$155,333.33 |
$155,333.33 |
$155,333.33 |
$155,333.33 |
$155,333.33 |
|
|
Add: Residual value of machine |
$15,000 |
||||||
|
Net annual cash flows |
$155,333.33 |
$155,333.33 |
$155,333.33 |
$155,333.33 |
$155,333.33 |
$170,333.33 |
|
|
Present value interest factor @ 15% |
0.87 |
0.756 |
0.658 |
0.572 |
0.497 |
0.432 |
|
|
Present value of annual cash flows |
$135,140.00 |
$117,432.00 |
$102,209.33 |
$88,850.67 |
$77,200.67 |
$73,584.00 |
|
|
Net Present value |
$94,416.67 |
Working notes:
1. We are given initial cost of machine at Year 0 is $500,000.
2. Annual sales = 45,000 units * $30 per unit = $1,350,000
3. Profit before depreciation and tax is calculated as Annual sales – (manufacturing cost + direct labor cost + misc. cost + advertising cost)
4. Annual depreciation = ($500,000 - $15,000)/6, since original cost = $500,000, residual value = $15,000, and life of machine = 6 years. So, annual depreciation = $80,833.33
5. Profit before tax = Profit before depreciation and tax – Depreciation
6. Tax = 40% * Profit before tax
7. Profit after tax = Profit before tax – tax
8. After-tax cash flows = Profit after tax + Depreciation added back
9. Net after-tax cash flows = After-tax cash flows + Residual value
10. Present value interest factor is taken from PVIF tables for each year @15% rate of return
11. Present value of annual cash flows = Net annual cash flows * Present value interest factor for each year
12. Net Present value = Total of present value of annual cash inflows – Initial investment of $500,000
NPV = $94,416.67
Ans.B. Payback period is the period within which initial investment is recovered back from annual cash inflows.
Payback period = Initial investment / Annual cash flows
Initial investment = $500,000
Annual cash flows = $155,333.33, except Year 6 when it is $170,333.33
Payback period = $500,000 / $155,333.33
= 3.22 years
Ans.C. Accounting rate of return is the average returns expected to be received on a project.
ARR = Annual net profits / Initial investment * 100
=Annual profit after tax = $74,500
ARR =( $74,500 / $500,000) * 100
= 14.9%
Ans.D. Based on the NPV, ARR and Payback period calculated, Van Doren can go ahead with the project because of the following :
1. NPV is positive $94,416.67 which means the project is yielding positive net cash flows in present value terms.
2. The accounting rate of return is 14.9%, which is just a tad below the required rate of return on capital of 15%
3. The payback period is also decent,i.e,3.22 years, halfway through the project
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