Question

Richards Tree Farm, Ltd. has branched into gardening over the years and is now considering adding patio furniture to its product lineup. Currently, the area where the patio furniture is to be displayed is a vacant slab of concrete attached to the indoor shop. The company originally paid $8,500 to put in the slab of concrete three years ago. It would now cost $12,000 to put in the same slab of concrete. It is estimated that the adjustments to the area would cost $25,000 but could be depreciated to zero over 5 years. The overhead allocation to the new project is expected to be $5000 per year. The new sales for the patio furniture are expected to be $40,000 with cost of goods sold of $30,000. However, it is expected that the sales from gardening supplies will increase by $8000 (COGS for gardening supplies is $6000). The patio furniture project is estimated to last 5 years. The marginal tax rate is 40% and the opportunity cost of capital is 12%. Should Richards Tree Farm proceed with the project?

SHOW ALL WORKINGS.

Answer 1

INITIAL INVESTMENT:
Adjustments to slab of concrete	$        25,000
OPERATING CASH FLOW:
Net operating income from patio sales = 40000-30000 =	$        10,000
Net operating income from sales of gardening supplies = 8000-6000 =	$          2,000
Depreciation [25000/5]	$          5,000
Incremental NOI	$          7,000
Tax at 40%	$          2,800
NOPAT	$          4,200
Add: Depreciation	$          5,000
Incremental OCF	$          9,200
NPV:
NPV = -25000+9200*(1.12^5-1)/(0.12*1.12^5) =	$        10,000
DECISION;
As the NPV is positive the project can be proceeded with.