LT INVESTMENT CORPORATION
The company is considering the establishment of a new product line which will involve the acquisition of new specialized equipment. This equipment would be used to produce the new product for a period of five years after which the firm estimates that competitive forces will eliminate the demand for this product.
1.Sales of this new product are expected to generate additional revenue of $750,000 in the first year and percentage changes from the prior year for Years 2 through 5 are as follows: Year 2 = +30%; Year 3 = +25%; Year 4 = a 10% decrease; and Year 5 = a 60% decrease. However, achievement of these revenues will require payment of a 5% sales commission in each year.
2.The new equipment will cost $1,500,000 (paid immediately), will have a useful life of five years, and at the end of five years this machine will have a salvage value of $200,000. The company depreciates all fixed assets on a straight-line basis for financial reporting, however for tax purposes this type of equipment may be depreciated over a three year period using the following depreciation schedule (salvage is not considered for tax depreciation purposes):
Year 1 / 50%Year 2 / 30%
Year 3 / 20%
3.An additional insurance policy will be required on the new equipment. A $20,000 premium would be paid immediately with an additional $5,000 to be paid at the end of three years. Because of a special clause in the policy, only 85% of these premiums would be deductible for tax purposes.
Another insurance policy will be acquired to protect the inventory of the new product. This policy would require annual premiums of $6,000 in years 1 through 5. These premiums would be 100% tax deductible.
4.In order to produce the new item and use the new equipment, we will be forced to use an existing storage warehouse as a production area. The warehouse has a book value of $500,000 and a remaining useful life of five years with a $40,000 salvage value at that time (straight-line depreciation is being used for both financial reporting and tax purposes). No salvage value is considered in determining depreciation.
Currently this warehouse is being leased to the Holloway Game Company for $20,000 per year for the next five years , but this lease can be canceled by paying them $50,000 immediately (this payment cannot be deducted for tax purposes).
5.If this new product line is introduced, the company plans to sell some material handling equipment which had been used in the warehouse mentioned in No. 4. This equipment will be sold for $40,000 at the end of the first year, at which time it will have a book value of $70,000.
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6.Other than the items previously mentioned, the new product would require normal variable cash operating expenses of 20% of sales. In addition, fixed cash operating costs for the first year of the project will be $100,000, and this amount will increase by 10% per year.
However, the experience gained using the new equipment for the new product will result in employee learning, some of which will transfer to other product lines within the company. This learning will result in the following cash operating savings over the next five years:
Year 1 / $100,000Year 2 / $30,000
Year 3 / $20,000
Year 4 / $10,000
Year 5 / $0
7.Our experience with similar projects has shown that in order to sustain the higher sales volume, additional investments in current assets, such as inventories and accounts receivable are required. The firm anticipates that an additional $200,000 would be required in Year 1, with an additional $250,000 in Year 3. These funds would become available for other projects at the termination of this product line. Hint: These are not considered "taxable events."
NOTE:Assume an income tax rate of 30% and that all tax effects occur at the same point in time as the related cash flows. This firm has a minimum desired rate of return of 12% after taxes.
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REQUIRED:
A.Assuming that you will be using the net present value technique, prepare a cash flow schedule showing the timing and amount of after-tax cash outflows and inflows for this project. Unless specifically indicated otherwise, assume cash flows occur at the end of the periods mentioned. Also assume all tax impacts occur at the same point as the underlying cash flows. Determine after-tax cash flows individually due to possible differences in tax treatments. Be sure to show the calculation of each of the cash flows clearly! Round all computations to the nearest whole dollar.
B.Compute the net present value of this project (using the present value factors indicated below) and state whether you should proceed with the investment in this product line (based solely on the quantitative analysis.
Present value of $1 at 12%
Period 1= .893
Period 2= .797
Period 3= .712
Period 4= .636
Period 5= .567
C.Discuss two specific strategic (qualitative) factors which might influence your decision about proceeding with such a project.
Revise your discounted cash flow analysis to illustrate how these qualitative factors might impact the projected net present value of the project.