Mayco, Inc
Subject:FinancePrice:2.86 Bought27
Mayco, Inc. would like to set up a new plant (expand). Currently, Mayco has an option to buy an existing building at a cost of $24,000. Necessary equipment for the plant will cost $16,000, including installation costs. The equipment falls into a MACRS 5-year class. The building falls into a MACRS 39-year class. The project would also require an initial investment of $12,000 in net working capital. The initial working capital investment will be made at the time of the purchase of the building and equipment. The project’s estimated economic life is four years. At the end of that time, the building is expected to have a market value of $15,000 and a book value of $21,816, whereas the equipment is expected to have a market value of $4,000 and a book value of $2,720.
Annual sales will be $80,000. The production department has estimated that variable manufacturing costs will total 60% of sales and that fixed overhead costs, excluding depreciation, will be $10,000 a year [costs: (0.60)80,000 + 10,000 = 58,000]. Depreciation expense will be determined for the year in accordance with the MACRS rate.
Mayco’s marginal federal-plus-state tax rate is 40%; its cost of capital is 12%; and, for capital budgeting purposes, the company’s policy is to assume that operating cash flows occur at the end of each year. The plant will begin operations immediately after the investment is made, and the first operating cash flows will occur exactly one year later.
The MACRS table is given below:
Property Class
| year | 3-year | 5-year | 7-year |
| 1 | 33.33% | 20% | 14.29% |
| 2 | 44.44% | 32% | 24.49% |
| 3 | 14.82% | 19.20% | 17.49% |
| 4 | 7.41% | 11.52% | 12.49% |
| 5 | 11.52% | 8.93% | |
| 6 | 5.76% | 8.93% | |
| 7 | 8.93% | ||
| 8 | 4.45% |
Required:-
? Compute the initial investment outlay. Also provide explanation of working.
? Compute the Operating cash flow over the project’s life. Also provide explanation of working.
? Compute the terminal year cash flows for Mayco’s expansion project. Also provide explanation of working.
? Determine whether the project should be accepted using NPV and IRR analysis. Also provide explanation of working.
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Ans :
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Answer 1 : |
Initial outlay |
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Price of building |
$24,000 |
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Price of equipment |
$16,000 |
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Net working capital |
$12,000 |
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|
$52,000 |
Note 1 : Under MACRS, the pre-tax depreciation for the building and equipment is:
Year 1 = $3,512; Year 2 = $5,744; Year 3 = $3,664; Year 4 = $2,544
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Answer 2 : |
Operating cash flows |
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PV OF Cash Flow Yr 1 : |
[(Sales – TC) (1- tax rate ) + After tax depreciation shield ] = [($80,000 - 58,000)(0.6)] + (3512)(0.4) |
$14,605 |
|
CF2 |
13,200 + (5,744)(0.4) |
$15,498 |
|
CF3 |
13,200 + (3,664)(0.4) |
$14,666 |
|
CF4 |
13,200 + (2,544)(0.4) |
$14,218 |
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Terminal year after-tax non-operating cash flows: |
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There are two elements to the terminal year cash flow (TNOCF): (1) return of net working capital and (2) salvage value of both the building and the equipment. |
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First calculate the after tax terminal cash flows associated with the building and the equipment separately: |
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CF for building = |
$15,000 - 0.4($15,000 - $21,816) = |
$17,726 |
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CF for equipment = |
$4,000 - 0.4($4,000 - $2,720) = |
$3,488 |
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Return of WC |
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$12,000 |
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Total |
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Using the expansion projects relevant after-tax cash flows and given that Mayco has a cost of capital of 12%, the NPV for the project can be computed as:
|
Year |
Cash Flow |
DF @ 12% |
PV |
|
|
(a) |
(b) |
(a*b) |
|
1 |
14605 |
0.8929 |
13040.17857 |
|
2 |
15498 |
0.7972 |
12354.91071 |
|
3 |
14666.00 |
0.7118 |
10438.96911 |
|
4 |
14218.00 |
0.6355 |
9035.796039 |
|
TV |
33214.00 |
0.6355 |
21108.09746 |
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Total Inflow = |
65977.9519 |
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Less: Outflow |
52000 |
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NPV |
13977.9519 |
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ACCEPT |
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IRR =(-52000,14605,15498,14666,14218,33214) |
|
19.71% |
Decision: Since NPV > 0 and the IRR > 1 2%, Mayco should accept the expansion project.
