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Chrysarbor Textiles is evaluating a new product, a silk/wool blended fabric. Assume that you were recently...

Chrysarbor Textiles is evaluating a new product, a silk/wool blended fabric. Assume that you were recently hired as assistant to the director of capital budgeting, and you must evaluate the new project.

The fabric would be produced in an unused building adjacent to Chrysarbor’s Hickory, North Carolina plant. Chrysarbor owns the building, which is fully depreciated. The required equipment would cost $200,000, plus an additional $40,000 for shipping and installation. In addition, inventories would rise by $25,000, while accounts payable would go up by $5,000. All of these costs would be incurred at Year 0. By a special ruling, the machinery could be depreciated under the MACRS system as 3-year property. (See Table 10A.2 at the end of Chapter 10 for MACRS recovery allowance percentages.)

The project is expected to operate for four years, at which time it will be terminated. The cash inflows are assumed to begin one year after the project is undertaken, or at t = 1, and to continue out to t = 4. At the end of the project’s life (Year 4), the equipment is expected to have a salvage value of $25,000.

Unit sales are expected to total 100,000 five-yard textile rolls per year, and the expected sales price is $2 per roll. Cash operating costs for the project (total operating costs less depreciation) are expected to total 60% of dollar sales. Chrysarbor’s marginal tax rate is 40%, and its required rate of return is 10%. Tentatively, the silk/wool blend fabric project is assumed to be of equal risk to Chrysarbor’s other assets.

You have been asked to evaluate the project and to make a recommendation as to whether it should be accepted or rejected. Your supervisor, Mr. Greg Ward,  gave you the following set of tasks to complete:

  1. Draw a cash flow time line that shows when the net cash inflows and outflows will occur, and explain how the time line can be used to help structure the analysis.
  2. Chrysarbor has a standard form that is used in the capital budgeting process and shown in the following table:

End of Year:                                              0                1                     2                3             4       

      Unit sales (Thousands) 100                                   

      Price/unit                                                              $ 2.00           $  2.00                                    

      Total revenues                                                                                              $200.0                 

      Costs excluding depreciation                                                  ($120.0)                                  

     Depreciation                                                                                                 (  36.0)    (  16.8)

        Total operating costs                                         ($199.2)         ($228.0)                                  

        Earnings before taxes (EBT)                                                                       $44.0

       Taxes                                                                (     0.3)                                               25.3

        Net income                                                                                                   $26.4

     Depreciation                                                             79.2                                36.0                

        Supplemental operating CF                                  $ 79.7                                              $ 54.7

     Equipment cost

     Installation

      Increase in inventory

      Increase in accounts payable

      Salvage value

      Tax on salvage value

      Return of net working capital                                                                                                  

      Cash flow timeline (net CF):              ($260.0)                                                               $ 89.7

     Cumulative CF for payback:               ( 260.0)      ( 180.3)                                              63.0

                           NPV =

                            IRR =

                    Payback =

Complete the table in the following order:

    1. Complete the unit sales, sales price, total revenues, and operating costs excluding depreciation lines.
    2. Complete the depreciation line.
    3. Now complete the table down to net income and then down to net operating cash flows.
    4. Now fill in the blanks under Year 0 and Year 4 for the initial investment outlay and the terminal cash flows and complete the cash flow time line (net CF). Discuss working capital. What would have happened if the machinery were sold for less than its book value?
  1. (1) Chrysarbor uses debt in its capital structure, so some of the money used to finance the project will be debt. Given this fact, should the projected cash flows be revised to show projected interest charges? Explain.

(2) Suppose you learned that Chrysarbor had spent $50,000 to renovate the building last year,

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Answer #1

Part (a)

Draw a cash flow time line that shows when the net cash inflows and outflows will occur, and explain how the time line can be used to help structure the analysis.

At t = 0 following cash flows occur:

  • Equipment Cost
  • Installation
  • Increase in inventory
  • Increase in accounts payable

At t = 1 to t=4 following operating cash flows occur every year:

  • Operating cash flow = (Sales - Total operating expenses - Depreciation) x (1 - Tax rate) + Depreciation

At t = 4, following terminal cash flows occur:

  • Post tax salvage value
  • Return of working capital

Part (b)

  1. Complete the unit sales, sales price, total revenues, and operating costs excluding depreciation lines.
  2. Complete the depreciation line.
  3. Now complete the table down to net income and then down to net operating cash flows.
  4. Now fill in the blanks under Year 0 and Year 4 for the initial investment outlay and the terminal cash flows and complete the cash flow time line (net CF).

For the four questions above, Please see the completed table below. In the second column i have indicated the formula used to calculate each of the rows.

Assumption: they is no alternate use to the depreciated building.

MARCS Dep rate

d

33.33%

44.45%

14.81%

7.41%

Tax rate

t

40%

All financials below in $ '000

End of Year:        

N

0

1

2

3

4

Unit sales (Thousand)

Q

100.0

100.0

100.0

100.0

Price / Unit

P

2.0

2.0

2.0

2.0

Total revenue

R = P x Q

200.0

200.0

200.0

200.0

Cost excluding depreciation

C = 60% x R

-120.0

-120.0

-120.0

-120.0

Depreciation

D = d x (C0 + C1)

-80.0

-106.7

-35.5

-17.8

Total operating costs

TOC = C + D

-200.0

-226.7

-155.5

-137.8

Earning before taxes (EBT)

R - TOC

0.0

-26.7

44.5

62.2

Taxes

T = t x EBIT

0.0

-10.7

17.8

24.9

NOPAT

EBIT - T

0.0

-16.0

26.7

37.3

Depreciation

D

80.0

106.7

35.5

17.8

Supplemental operating CF

NOPAT + D

80.0

90.7

62.2

55.1

Equipment Cost

C0

-200.0

Installation

C1

-40.0

Increase in inventory

I

-25.0

Increase in accounts payable

P

5.0

Salvage value

S

25.0

Tax on salvage value

t x S

-10.0

Return of net working capital

-(I + P)

20.0

Cash flows

CF

-260.0

80.0

90.7

62.2

90.1

Cumulative Cash flows

-260.0

-180.0

-89.3

-27.1

63.0

Discount rate

R

10%

Discount factor

(1+R)^(-N)

1.0000

0.9091

0.8264

0.7513

0.6830

PV of Cash flows

PV factor x CF

-260.0

72.7

74.9

46.7

61.5

NVP

Sum of all PV

-4.0

IRR

IRR using excel function

9.28%

Payback (years)

Interpolate between year 3 & 4

3.30

Calculated as 3+27.1/90.1

Discuss working capital.

Increase in Working capital in this case will be increase in inventory offset by increase in payables.

What would have happened if the machinery were sold for less than its book value?

If the machinery is sold below its tax basis, in that case there will be a loss on sale of the machinery. This loss can result into tax savings on profits elsewhere in the business. Hence its. post tax salvage value will be more than the cash proceeds received from the sale.

Part b (1)

Chrysarbor uses debt in its capital structure, so some of the money used to finance the project will be debt. Given this fact, should the projected cash flows be revised to show projected interest charges? Explain.

Since we are doing capital budgeting analysis at the project level, all our capital budgeting tools should be required on the unlevered cash flows.Hence, capital structure or the means of finance or sources of funds should not impact the cash flows used for capital budgeting. Operating and financing decisions are treated separately under capital budgeting. Hence the projected cash flows need not be revised to show projected interest charges.

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