The Lucky Seven Company is an international clothing manufacturer. Its Redmond plant will become idle on December 31, 2014. Peter Laney, the corporate controller, has been asked to look at three options regarding the plant:
Option 1: The plant, which has been fully depreciated for tax purposes, can be sold immediately for $ 900,000.
Option 2: The plant can be leased to the Preston Corporation, one of Lucky Seven’s suppliers, for 4 years. Under the lease terms, Preston would pay Lucky Seven $ 220,000 rent per year (payable at year-end) and would grant Lucky Seven a $ 40,000 annual discount off the normal price of fabric purchased by Lucky Seven. (Assume that the discount is received at year-end for each of the 4 years.) Preston would bear all of the plant’s ownership costs. Lucky Seven expects to sell this plant for $ 150,000 at the end of the 4-year lease.
Option 3: The plant could be used for 4 years to make souvenir jackets for the Olympics. Fixed over-head costs (a cash outflow) before any equipment upgrades are estimated to be $ 20,000 annually for the 4-year period. The jackets are expected to sell for $ 55 each. Variable cost per unit is expected to be $ 43. The following production and sales of jackets are expected: 2015, 18,000 units; 2016, 26,000 units; 2017, 30,000 units; 2018, 10,000 units. In order to manufacture the jackets, some of the plant equipment would need to be upgraded at an immediate cost of $ 160,000. The equipment would be depreciated using the straight-line depreciation method and zero terminal disposal value over the 4 years it would be in use. Because of the equipment upgrades, Lucky Seven could sell the plant for $ 270,000 at the end of 4 years. No change in working capital would be required. Lucky Seven treats all cash flows as if they occur at the end of the year, and it uses an after-tax required rate of return of 10%.
Lucky Seven is subject to a 35% tax rate on all income, including capital gains.

1. Calculate net present value of each of the options and determine which option Lucky Seven should select using the NPV criterion.
2. What nonfinancial factors should Lucky Seven consider before making itschoice?

  • CreatedMay 14, 2014
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