Managers at Mattel have already spent a total of $100,000 each on its 45th Presidential action doll ($50,000 on developing the Trump doll and $50,000 on the Clinton doll). After the winner of the presidential election is determined (end of 2016), it will begin producing the doll of the winner only. They will use a small factory it already owns that has an after-tax market value of $5,000,000. A new machine will be purchased for $1,000,000, which will be straight-line depreciated to zero over four years. Sales are projected to be $2,000,000 in 2017 and to decrease by 40% every year until the term of the next president ends in 2020. Mattel will stop making and selling this doll at that time. Cost of goods sold will be 50% of sales. In 2016, Mattel will purchase $200,000 in inventory and maintain this amount of additional inventory until 2020 when it will liquidate it. When the project is abandoned in four years, the value of the plant will be $5,000,000 and the machine will have a pre-tax salvage value of $250,000. Assume that Mattel’s corporate tax rate is 35%.
Q1) What is the free cash flow this project in 2016 (year 0)?
A) -$6,200,000
B) -$6,300,000
C) -$6,400,000
D) -$1,200,000
E) -$1,300,000
Q1)
Free cash flow in Year 0 = - (cost of machine + investment in inventory)
Free cash flow in Year 0 = - ($1,000,000 + $200,000)
Free cash flow in Year 0 = -$1,200,000
The answer is D
The amount spent on development is a sunk cost since it is incurred in the past, and not an incremental cash flow. This amount should not be considered in the cash flow analysis.
The value of the factory already owned is also not an incremental cash flow because it is already owned, and there is no intention of selling the factory if the project is not undertaken. The value of factory should also not be considered in the cash flow analysis.
Managers at Mattel have already spent a total of $100,000 each on its 45th Presidential action...