Rob Roy Corporation has, for the last three years, been using its present facilities at its annual full capacity of 10,000 units. Still, the company is unable to keep pace with continuing demand for the product that is estimated to be 25,000 units annually. This demand level is expected to continue for at least another four years. To expand manufacturing capacity and take advantage of the demand, Rob Roy must acquire equipment costing $1,000,000. The equipment will double the current production quantity. This equipment has a useful life of 10 years and can be sold for $200,000 at the end of year 4 or for $30,000 at the end of year 10. Analysis of current operating data provides the following information:

Problem Information

Current capacity level (units) ……………………………………………	10,000
Total estimated demand (units) ………………………………………….	25,000
Minimum duration of increased demand (years) …………………………	4
Investment cost, year 0 ………………………………………………..	$1,000,000
Estimated salvage value, after 4 years ………………………………….	$200,000
Estimated salvage value, after 10 years …………………………………	$30,000
Estimated life of new equipment (in years) ………………………………	10
% increase in capacity …………………………………………………	200%
Additional fixed mfg costs (beyond depreciation on new machine) ………	250000 per year
After-tax discount rate (WACC) ……………………………………….	14%
Income tax rate …………………………………………………………	35%
Additional fixed mktg costs (cash) per year ……………………………..	$200,000
Increase in output volume (units) ………………………………………..	10,000

The fixed costs include depreciation expense of the current equipment. The new equipment will not change variable costs, but the firm will incur additional fixed manufacturing costs (excluding depreciation) of $250,000 annually. The firm needs to spend an additional $200,000 in fixed marketing costs per year for additional sales. Rob Roy is in the 35% tax bracket. Management has set a minimum rate of return of 14% after-tax for all capital investments. Assume, for simplicity, that MACRS depreciation rules do not apply.

Requirements
1. Assume that the equipment will be depreciated over a four-year period. What effects will the new equipment have on net income in each of the four years?
2. What effect will the new equipment have on cash flows in each of the four years?
3. Compute the proposed investment's payback period (in years) under the assumption that cash flows occur evenly throughout the year.
4. Compute the accounting (book) rate of return (ARR) based on the average investment.
5. Compute the net present value (NPV) of the proposed investment
6. Compute the internal rate of return (IRR) of the proposed investment
7. Compute the modified internal rate of return (MIRR)
8. Management has decided to invest in the new equipment, but is unsure of the reliability of some of the estimates and as such has asked some what-if questions. Treat each of the following two cases independently.
a. By how much can the unit variable cost for units produced by the new equipment increase and still justify the purchase of the equipment (i.e., have the investment generate an after-tax IRR of exactly 14 percent, its cost of capital)?
b. The company is anticipating an increase in competition. Management believes that, in response, it will have to reduce the selling price of the product. By how much can the firm decrease the selling price (of all units sold) and still be able to justify the purchase of the new equipment?
9. What strategic considerations bear on the equipment-purchase decision?

Transcribed Image Text:

Per Unit S200 Sales price Variable costs S97 $10 Marketing Fixed costs S45 $25 Other S70 S177 Pretax operating income $23