Question

Melbourne Metal is considering becoming a supplier of transmission housings. It would require buying a new forge that would cost $125,000 (including all setup costs) and is expected to last five years. Let the asset life be the life of the project. Melbourne Metal does a best guess (Base) study of their costs and revenues. They anticipate setting their price at p $50 per unit and they estimate the annual demand is q 2,500 10p. Variable costs (labour, materials, etc.) are estimated to be $15 per unit. Total fixed costs (excluding depreciation of the forge) is estimated to be $10,000 per year. Melbourne Metal uses the double declining balance method for depreciation. The book balance at the start of year 1 is the S125,000. The depreciation in a year is a fixed percentage 0 < a of the beginning of year book balance where the book balance at the beginning of year n is the book balance at the end of year n-1. The book balance at the end of year n, B depreciation that year. With the double declining balance method, the depreciation rate a where N is the life of the project. The salvage value is assumed to the book 2 balance at the end of the project. The tax rate is 40%. The MARR is 15%. Set up an Income Statement and calculate annual net income for each year of the project. (15)

Answer 1

Sale Price is $50, hence q = 2500-10p = 2500 - 10*50 = 2500-500 = 2000 units

Hence Revenue = Quantity * Price = 2000*50 = $100,000. This will be revenue for all years

Variable Cost is $15 per unit, Total Variable cost = 2000*15 = $30,000. This variable cost will be for all years

Fixed cost is $10000 per year for all years

Hence Earning before tax and depreciation will be revenue - fixed cost-variable cost = 100000-10000-30000=$60000. This is same for all years

For Depreciation α = 2/N = 2/5 =40%

Book Value at start of year 1: $125,000

Depreciation at year 1 = 40% * 125000 = $50000, Earning Before Tax for year 1 =  Earning before tax and depreciation- Depreciation = 60000-50000 =$10000

Book Value at start of year 2 = 125000-50000 = $75000

Depreciation at year 2 = 40% * 75000 = $30000, Earning Before Tax for year 2 =  Earning before tax and depreciation- Depreciation = 60000-30000 =$30000

Book Value at start of year 3 = 75000-30000 = $45000

Depreciation at year 3 = 40% * 45000 = $18000, Earning Before Tax for year 3 =  Earning before tax and depreciation- Depreciation = 60000-18000 =$42000

Book Value at start of year 4 = 45000-18000 = $27000

Depreciation at year 4 = 40% * 27000 = $10800, Earning Before Tax for year 4  =  Earning before tax and depreciation- Depreciation = 60000-10800 =$49200

Book Value at start of year 5 = 27000-10800 = $16200

Depreciation at year 5 = 40% * 16200 = $6480, Earning Before Tax for year 1 =  Earning before tax and depreciation- Depreciation = 60000-6480 =$53520

Book Value at end of 5 year = 16200-6480= $9720

Taxes will be 40% of Earning before Tax

Tax year 1 = 40% *10000 = $4000

Tax year 2 = 40% *30000 = $12000

Tax year 3 = 40% *42000 = $16800

Tax year 4 = 40% *49200 = $19680

Tax year 5 = 40% *53520 = $21408

Net Income = Earning before Tax- Tax

Net Income Year 1 = 10000-4000 = $6000

Net Income Year 2 = 30000-12000 = $18000

Net Income Year 3 = 42000-16800 = $25200

Net Income Year 4 = 49200-19680 = $29520

Net Income Year 5 = 53520-21408 = $32112

Hence Income Statement will be as follows:

	Yr1	Yr2	Yr3	Yr4	Yr5
Revenue	100000	100000	100000	100000	100000
(-)Variable Cost	30000	30000	30000	30000	30000
(-) Fixed Cost	10000	10000	10000	10000	10000
Earning Before Depreciation and Tax	60000	60000	60000	60000	60000
(-) Depreciation	50000	30000	18000	10800	6480
Earning before Tax	10000	30000	42000	49200	53520
(-)Taxes	4000	12000	16800	19680	21408
Net Income	6000	18000	25200	29520	32112