91Ó°ÊÓ

Unbreakable Manufacturing manufactures over 20,000 different products made from metal, including building materials, tools, and furniture parts. The manager of the furniture parts division has proposed that his division expand into bicycle parts as well. The furniture parts division currently generates cash revenues of \(\$ 5,000,000\) and incurs cash costs of \(\$ 3,550,000,\) with an investment in assets of \(\$ 12,050,000 .\) One-fourth of the cash costs are direct labor. The manager estimates that the expansion of the business will require an investment in working capital of \(\$ 25,000 .\) Because the company already has a facility, there would be no additional rent or purchase costs for a building, but the project would generate an additional \(\$ 390,000\) in annual cash overhead. Moreover, the manager expects annual materials cash costs for bicycle parts to be \(\$ 1,300,000,\) and labor for the bicycle parts to be about the same as the labor cash costs for furniture parts. The controller of Unbreakable, working with various managers, estimates that the expansion would require the purchase of equipment with a \(\$ 2,575,000\) cost and an expected disposal value of \(\$ 370,000\) at the end of its seven- year useful life. Depreciation would occur on a straight-line basis. The \(\mathrm{CFO}\) of Unbreakable determines the firm's cost of capital as \(14 \%\). The CFO's salary is \(\$ 150,000\) per year. Adding another division will not change that. The CE0 asks for a report on expected revenues for the project, and is told by the marketing department that it might be able to achieve cash revenues of \(\$ 3,372,500\) annually from bicycle parts. Unbreakable Manufacturing has a tax rate of \(35 \%\). 1\. Separate the cash flows into four groups: (1) net initial investment cash flows, (2) cash flows from operations, (3) cash flows from terminal disposal of investment, and (4) cash flows not relevant to the capital budgeting problem. 2\. Calculate the NPV of the expansion project and comment on your analysis.

Step by step solution

01

Identify Net Initial Investment Cash Flows

The net initial investment will include the cost of purchasing the equipment and the investment in working capital. Thus, we need to account for:- Equipment purchase cost: \(\\( 2,575,000\).- Increase in working capital: \(\\) 25,000\).Therefore, the total net initial investment is \(\\( 2,575,000 + \\) 25,000 = \$ 2,600,000\).

02

Determine Cash Flows from Operations

Operational cash flows are calculated using expected revenue, less operational costs, and taxes. Here's what to consider:- Annual cash revenue from bicycle parts: \(\\( 3,372,500\).- Additional overhead: \(\\) 390,000\).- Materials cost for bicycle parts: \(\\( 1,300,000\).- Labor cost for bicycle parts (same as 1/4 of current labor): \(\frac{1}{4} \times \\) 3,550,000 = \\( 887,500\).- Total operating costs: \(\\) 390,000 + \\( 1,300,000 + \\) 887,500 = \\( 2,577,500\).- Pre-tax cash flow: \(\\) 3,372,500 - \\( 2,577,500 = \\) 795,000\).- Tax paid at 35%: \(0.35 \times \\( 795,000 = \\) 278,250\).- After-tax cash flow: \(\\( 795,000 - \\) 278,250 = \$ 516,750\).

03

Calculate Cash Flows from Terminal Disposal of Investment

Terminal cash flows involve the disposal of equipment and the recovery of working capital at the end of the project's life:- Disposal value of equipment: \(\\( 370,000\).- Working capital recovery: \(\\) 25,000\).Therefore, total terminal cash flows are \(\\( 370,000 + \\) 25,000 = \$ 395,000\).

04

Identify Cash Flows Not Relevant to Capital Budgeting

The cash flows that do not affect the capital budgeting decisions include:- CFO's salary \(\$ 150,000\) since it remains unchanged.These do not impact the calculation of the NPV of the expansion project.

05

Calculate Depreciation Expense

Depreciation affects taxable income, which in turn affects cash flows. Calculate straight-line depreciation:- Total depreciation expense over 7 years: \(\\( 2,575,000 - \\) 370,000 = \\( 2,205,000\).- Annual depreciation: \(\frac{\\) 2,205,000}{7} = \$ 315,000\).

06

Calculate Net Present Value (NPV)

NPV is calculated using cash flows over 7 years and a cost of capital of 14%:1. Calculate after-tax savings from depreciation: \(\\( 315,000 \times 0.35 = \\) 110,250\).2. Total annual cash flow: \(\\( 516,750 + \\) 110,250 = \\( 627,000\).3. Discount factor for NPV (yearly) calculation: \[NPV = -\\) 2,600,000 + \sum_{t=1}^{7}\frac{\\( 627,000}{(1+0.14)^t} + \frac{\\) 395,000}{(1+0.14)^7} \]4. Compute the NPV using financial calculators or software for precise results.

07

Analyze the NPV Result

If the NPV is positive, the expansion project is expected to add value to the company. In this step, a positive NPV would suggest that Unbreakable Manufacturing should consider expanding into bicycle parts due to anticipated positive cash inflows over the project's lifetime.

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Key Concepts

These are the key concepts you need to understand to accurately answer the question.

Net Present Value (NPV)

Net Present Value, or NPV, is a core concept in capital budgeting. It is used to evaluate the profitability of an investment or project. By calculating NPV, we essentially determine the present value of future cash inflows and outflows related to a project. Here's how it works:

• First, identify all incoming and outgoing cash flows associated with the project. This includes initial investments, operating cash flows, and terminal cash flows at the end of the investment.
• Use the firm's cost of capital to discount these cash flows back to their present value. This process is crucial as it helps account for the time value of money, which is the idea that a dollar today is worth more than a dollar tomorrow.
• To determine NPV, sum up all present values of the cash flows. A positive NPV indicates that the project is expected to generate more cash than it costs, thus adding value to the firm.

Understanding NPV helps decision-makers analyze whether engaging in a new project, such as expanding into bicycle parts, is financially wise. Essentially, it tells if the future benefits of the project outweigh the present costs.

Cash Flow Analysis

Cash flow analysis plays a vital role in determining the feasibility of any capital investment project. It involves examining and categorizing all cash flows related to a project. Let's break down key elements of cash flow analysis in capital budgeting:

• Net Initial Investment Cash Flows: This includes any immediate cash outlays required to start the project, like purchasing equipment and investing in working capital. For the bicycle parts project, this consists of equipment costs and an increase in working capital.
• Operating Cash Flows: These are the net cash flows generated from the project's operational activities. Key components are cash revenues from sales, minus cash expenses such as material costs, labor, and additional overheads. Taxes also play a part here, impacting the net cash generated.
• Terminal Disposal of Investment Cash Flows: At the project's end, this includes any cash received from selling equipment and recovering working capital. It helps in understanding the project's closing cash position.

Packing all these into a structured analysis provides a complete picture of how a project will perform and whether it aligns with the firm's financial goals.

Depreciation Calculation

Depreciation is a non-cash expense that affects the company's taxable income and cash flow. In capital budgeting, calculating depreciation accurately is important:

• For Unbreakable Manufacturing's bicycle expansion project, we use straight-line depreciation. This involves evenly spreading the cost of an asset over its useful life.
• To calculate, subtract the equipment's salvage value from its purchase cost, and divide by its useful lifespan. This gives us the annual depreciation expense. Here, that would be \[ \frac{2,575,000 - 370,000}{7} = 315,000 \]
• Depreciation does not directly affect cash flow since it’s not an actual outlay. However, it reduces taxable income, thus lowering the taxes a company pays, which indirectly boosts the net cash flow.
• The tax savings from depreciation are a key consideration in NPV calculations, as they enhance cash inflows over the project's duration.

Understanding depreciation in terms of its effects on capital budgeting processes helps managers better gauge the financial viability of a prospective project.