9.

The Leventhal Baking Company is thinking of expanding its operations into a new line of
pastries. The firm expects to sell $350,000 of the new product in the first year and $500,000 each
year thereafter. Direct costs including labor and materials will be 60% of sales. Indirect
incremental costs are estimated at $40,000 a year. The project will require several new ovens that
will cost a total of $500,000 and be depreciated straight line over five years. The current plant is
underutilized, so space is available that cannot be otherwise sold or rented. The firm's marginal
tax rate is 35%, and its cost of capital is 12%. Assume revenue is collected immediately and
inventory is bought and paid for every day, so no additional working capital is required.
a. Prepare a statement showing the incremental cash flows for this project over an 8-year period.
b. Calculate the Payback Period, NPV, and IRR.
c. Recommend either acceptance or rejection.
d. If the space to be used could otherwise be rented out for $30,000 a year, how would you put
that fact into the calculation. Would the project be acceptable in that case?
SOLUTION:
a.
CASH FLOWS ($000)
Ovens
Revenue
Direct Cost
Indirect Cost
Depreciation
EBT Contribution
Tax
EAT Contribution
Add Back Depreciation
NCF

0
($500)

1
$350
( 210)
( 40)
( 100)
$ 0

($500)

$ 0
$100
$100

2-5
$500
( 300)
( 40)
( 100)
$ 60
($ 21)
$ 39
$100
$139

6-8 ___
$500
( 300)
( 40)
-__
$ 160
($ 56)
$ 104
$104

b.
Year
0
1
2
3
4

NCF
($500)
$100
$139
$139
$139

Cum CF
($500)
($400)
($261)
($122)
$ 17
P/B Period = 3.9 yrs

CF0 = -500
CF1 = 100
CF2-5 = 139
CF6-8 = 104
I = 12
Shift NPV = 107.98
Shift IRR = 18.03%
c.
d.
effect

Accept, since NPV > 0 and IRR > 12%.

It would add a $30,000 per year pre-tax opportunity cost to the analysis. The after-tax
is
$30,000 .65 = $19,500

The impact on the analysis would be to reduce the NPV by the present value of an 8-year annuity
of this amount. [You could also simply re-budget the operating cash flow budget and then
recalculate the NPV with the new cash flows.] Stated in thousands ($000):
PVA = $19.5 [PVFA12,8]
= $19.5 (4.9676)
= $97
Then,
Revised NPV = Old NPV $97
= $108 $97
= $11
Hence the project would be marginally acceptable under this added condition.
15.
The Catseye Marble Co. is thinking of replacing a manual production process with a
machine. The manual process requires three relatively unskilled workers and a supervisor. Each
worker makes $17,500 per year while the supervisor earns $24,500. The new machine can be run
with only one skilled operator who will earn $41,000. Payroll taxes and fringe benefits are an
additional one third of all wages and salaries.
The machine costs $150,000 and has a tax depreciation life of five years. Catseye elects
straight- line depreciation for tax purposes. A service contract covers all maintenance for $5,000
a year. The machine is expected to last six years, at which time it will have no salvage value.
The machine's output will be virtually indistinguishable from that of the manual process in both
quality and quantity. There are no other operating differences between the manual and the
machine processes. Catseye's marginal tax rate is 35%, and its cost of capital is 10%.
a. Calculate the incremental cash flows associated with the project to acquire the machine.
b. Calculate the project's payback and NPV. Would you accept or reject the project?
c. Suppose there is no alternative but to lay off the displaced employees, and the cost of
severance is about three months wages. How would you factor this information into the
analysis? Does it change the project's acceptability?
d. How would you characterize this project's risk?
SOLUTION:
a.
Annual labor savings:
Old labor:
$17,500 3 + $24,500 =
$77,000
New labor:
$41,000
Savings
$36,000
Fringe Benefits @ 1/3
$12,000
Annual Labor Savings
$48,000
(you can add the fringes prior to taking the net on labor you get the same either way)
CASH FLOWS ($000)
Asset
Labor Savings
Maintenance cost
Depreciation
EBT Contribution
Tax
Add Back Depreciation

0
($150,000)

1-5

6_

$48,000
$48,000
($ 5,000)
($ 5,000)
($30,000)
-___
$13,000
$43,000
($ 4,550)
($15,050)
$30,000
-___

Annual CF

($150,000)

$38,450

$27,950

b.

Payback Period = $150,000 / $38,450 = 3.9 years

NPV = $150,000 + $38,450 [PVFA10,5] + $27,950 [PVF10,6]
= $150,000 + $38,450 (3.7908)+ $27,950 (.5645)
= $11,534
A positive NPV indicates an acceptable project.

c.

Three months severance, after tax, on old wages would increase initial cost by:
$77,000 (3/12) 1.333 .65 = $16,679
This would decrease the NPV to
NPV = $11,534 $16,679 = $5,145, and make the project unacceptable.

d.
This project would probably be somewhat riskier than the usual replacement, because the
machine is a new and unfamiliar way of doing the job.