Question

4.. Net Present Value. (CMA adapted) Crescent Industries is a toy manufacturer that will have excess capacity at its single plant after 20x2. Crescent's management is currently studying two alternative proposals that would utilize the excess capacity. Proposal Crescent has been approached by Happy-Toys, one of its competitors, to manufacture a partially completed toy car. Happy-Toys, owner of the distribution rights for the toy car, would finish the cars in its plant and then market the cars. The Happy-Toy car would not compete directly with any of Crescent's products. Happy-Toys would contract to purchase 5,000 unfinished cars each month at a price of $7.50 each for the period of 20x3 through 20x6. Crescent's estimated incremental cash outlays to manufacture the car would be $250,000 per year during the four-year contract period. In addition, this alternative would require a $400,000 investment in manufacturing equipment. The equipment would have no salvage value at the end of its useful life. Proposal 11 Crescent is considering the production of a new water toy to be added to its own product line. The new water toy would be sold at $15 per unit and the expected annual sales over the estimated six-year product life (20x3-20x8) for the toy are as follows: Annual Unit Year Sales 20x3 65,000 20x4 90,000 20x5 90,000 20x6 65,000 20x7 50,000 20x8 50,000 The variable unit manufacturing and selling costs are estimated to be $6.00 and $1.00 respectively over the six-year period. The estimated annual incremental cash outlay for fixed costs would be $300,000. The manufacture and sale of the new water toy would require a $700,000 investment in new manufacturing equipment; this equipment would have a salvage value of $50,000 at the end of the six-year period. Additional information relative to a decision between the two proposals follows: Manufacturing equipment for either proposal would be placed in service during December 20x2. Depreciation on the equipment would be recognized starting in 20x3. Straight-line depreciation over the life of the proposal would be used for book purposes and ACRS for three-year property would be employed for tax purposes. The ACRS personal property rates are presented below. ACRS Tables for Three-Year Property Year 1-25% Year 2-38% Year 3-37% Crescent's management assumes that annual cash flows occur at the end of the year for evaluating capital investment proposals. Crescent uses a 16 percent after-tax discount rate. Crescent is subject to a 30% income tax rate. REQUIRED: Calculate the net present value at December 31, 20x2 of the estimated after-tax cash flows of Crescent Industries' proposal of: 1. 2. Manufacturing unfinished toy cars for Happy-Toys. Manufacturing and selling a new water toy to be added to its own product line.

Answer 1

Proposal 1

Year for proposal	0	1	2	3	4
Year Actual	20x2	20x3	20x4	20x5	20x6
Sales ( 5,000 * $7.50 * 12 months)		450,000	450,000	450,000	450,000
Less:- Incremental Cash Outlay		(250,000)	(250,000)	(250,000)	(250,000)
Less:- Depreciation as per ACRS		(100,000)	(152,000)	(148,000)	-
Net Profit Before Tax		100,000	48,000	52,000	200,000
Less:- Tax @ 30%		(30,000)	(14,400)	(15,600)	(60,000)
Net Profit After Tax		70,000	33,600	36,400	140,000
Add:- Depreciation		100,000	152,000	148,000	-
Cash Flow From Operations		170,000	185,600	184,400	140,000
Purchase of Equipment	(400,000)
Total Cash Flows	(400,000)	170,000	185,600	184,400	140,000
PV Factor @ 16%	1.000000	0.862069	0.743163	0.640658	0.552291
PV of Total Cash Flows	(400,000.00)	146,551.72	137,931.03	118,137.28	77,320.75
Net Present Value of Proposal 1	79,940.79

Proposal 2

Contribution per unit = Sale Price- Manufacturing - Selling Expense = 15 - 6 -1 =$8 per unit

Year for proposal	0	1	2	3	4	5	6
Year Actual	20x2	20x3	20x4	20x5	20x6	20x7	20x8
Sales (in Units)		65,000	90,000	90,000	65,000	50,000	50,000
Contribution Per Unit		8	8	8	8	8	8
Contribution Margin (Sales * $8)		520,000	720,000	720,000	520,000	400,000	400,000
Less:- Incremental Cash Outlay		(300,000)	(300,000)	(300,000)	(300,000)	(300,000)	(300,000)
Less:- Depreciation as per ACRS		(175,000)	(266,000)	(259,000)	-	-	-
Add:- Gain on Sale of Equipment		-	-	-	-	-	50,000
Net Profit Before Tax		45,000	154,000	161,000	220,000	100,000	150,000
Less:- Tax @ 30%		(13,500)	(46,200)	(48,300)	(66,000)	(30,000)	(45,000)
Net Profit After Tax		31,500	107,800	112,700	154,000	70,000	105,000
Add:- Depreciation		175,000	266,000	259,000	-	-	-
Cash Flow From Operations		206,500	373,800	371,700	154,000	70,000	105,000
Purchase of Equipment	(700,000)
Total Cash Flows	(700,000)	206,500	373,800	371,700	154,000	70,000	105,000
PV Factor @ 16%	1.000000	0.862069	0.743163	0.640658	0.552291	0.476113	0.410442
PV of Total Cash Flows	(700,000.00)	178,017.24	277,794.29	238,132.46	85,052.83	33,327.91	43,096.44
Net Present Value of Proposal 2	155,421.17

Note:- The Salvage value of $50,000 in proposal 2 is treated as normal income and fully taxed at 30% because earlier depreciation for full $700,000 had been taken. Alternate treatment according to country and tax laws may be possible.

The Net Present Value of the two proposals has been calculated as above.

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