Question

Please answer all three. Thank you.

Bailey Sheppard Corp. ("BSC") manufactures musical equipment and is evaluating the economics of expanding its manufacturing facility to enable it to take on a new business customer contract for the next 4 years. Last year, the company paid Target Research LLC $35,000 to do a marketing research study for its product lines. The current expansion scenario would have total construction costs of $1.3 million and it would take about 50 days to complete lie., essentially up-front). The Company would also put in $250 thousand of new machinery. Inventory (raw materials, work-in-process, finished goods) investment needed for the expansion would be $65 thousand. Annual depreciation associated with the expansion would be $150 thousand per year for the next four years, but the company has decided for income tax purposes to expense 100% of the cost of the long-term assets in Year 0. The company expects to borrow 100% of the upfront costs and thereby incur $646 thousand in total interest expense over the life of the project. Incremental sales for this project are estimated to be $1.2 million for Year 1: $1.9 million for Year 2: $2.1 million for Year 3; and $1.2 million for Year 4. Cost of goods sold is estimated to be approximately 50% of total sales, and additional fixed costs are estimated to be $100 thousand per year. At the end of the project's estimated life in Year 4, the company estimates it will be able to sell excess capital assets for $125.000 and the expected book value for these items would be $0 (zero). Also at the end of the project. $40,000 of remaining inventory could be liquidated at cost. The weighted average cost of capital is 16%, iti assumed marginal income tax rate is 25%, and its capital gains tax rate is 25%. Is(Are) there any irrelevant cash flow(s) mentioned in this problem? If so, what isare) It(they)? Yes, the interest expense, the excess inventory sold in Year 4, and the market research study Yes, the interest expense and the market research study No. There are none Yes, the market research study Yes, the interest expense.

Answer 1

Irrelevant Cash Flows:

Particulars Marketing Research Study Total Construction Costs New Machinery Inventory Investment Annual Depreciation Interest Expenses Incremental Sales - Year 1 Incremental Sales - Year 2 Incremental Sales - Year 3 Incremental Sales - Year 4 Cost of goods sold Additional Fixed Costs Sell excess assets Remaining Inventory liquidation Relevant / Irrelevant Amount cash Flow Remarks $35,000 Irrelevant This is a sunk cost. This does not influence the future cash-flows of the project $1,300,000 Relevant Cost to be incurred if the project is undertaken $250,000 Relevant Cost to be incurred if the project is undertaken $65,000 Relevant Cost to be incurred if the project is undertaken $150,000 Relevant Depreciation has tax benefits which will impact the future cash flow $646,000 Relevant Cost to be incurred on the borrowed amount if the project is undertaken $1,200,000 Relevant Incremental sales directly associated with the project $1,900,000 Relevant Incremental sales directly associated with the project $2,100,000 Relevant Incremental sales directly associated with the project $1,200,000 Relevant Incremental sales directly associated with the project 50% of sales Relevant Incremental costs directly associated with the project $100,000 Relevant Incremental costs directly associated with the project $125,000 Relevant Salvage Value at the end of the project $40,000 Relevant Salvage Value at the end of the project

Thus, as can be seen, except for Marketing Research Study costs, all other costs are relevant costs and only the Marketing Research Study costs are irrelevant.

Hence answer is, Yes , the market research study (4th option)

After Tax Salvage Value:

A B с 1 2 3 Cost of Telephone system 4 years ago 4 Book Value end of 5 years 5 Depreciable base 6 Life of Telephone system (years) 7 Depreciation per annum 8 Book Value now (after 4 years of purchase) 9 Market Value now 10 Profit on sale 11 Tax on Profit at 21% 12 After-Tax Salvage Value $2,250,000 Given in question $50,000 Given in question $2,200,000 =B3-B4 5 Given in question $440,000 =B5/B6 $490,000 =B3-(B7*4) $800,000 Given in question $310,000 =B9-B8 $65,100 =B10*21% $734,900 =B9-B11

After-Tax Salvage Value = $734,900 (first option)

Question 29

When the project project is analysed, the purchase cost of land of $120,500 2 years ago is a sunk cost as the same doesnt impact or influence the future cash-flow associated with the project and hence is not relevant.

The market value of $335,000 now is a relevant cash-flow --- this represents a opportunity cost as if the project be undertaken, the land wouldnt have been sold.

Since depreciation is not applicable on land, if there are tax liability for the friends, then tax will be paid on the excess of market value over purchase property ($335,000-$120,500) and net relevant cost will be the after tax market value. However, the question is silent on tax and hence the impact is not considered.

Thus, the answer is Yes, it was relevant to the analysis and the historical cost of the land was a sunk cost. (2nd option)