2. Cash flows Reliable Electric, a major Ruritanian producer of electrical products, is considering a proposal...

 

  

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2. Cash flows Reliable Electric, a major Ruritanian producer of electrical products, is considering a proposal to manufacture a new type of industrial electric motor that would replace most of its existing product line. A research breakthrough has given Reliable a two- year lead on its competitors. The project is not expected to be viable for more than ten years. The project proposal is summarized in the table below. a. Read the notes to the table carefully. Which entries make sense? Which do not? Why or why not? b. What additional information would you need to construct a version of the table that makes sense? c. Construct such a table and recalculate NPV. Explicitly state any additional assumptions you find necessary. (1) Capital expenditure (2) Research and development (3) Working capital (4) Revenue (5) Operating costs (6) Overhead (7) Depreciation (8) Interest (9) Income (10) Tax @21% (11) Net cash flow (12) Net present value 2019 (11,500) (2,000) 4,000 (2,000) (17,500) 20,719 2020 2021 2022-2029 7,900 15,800 39,500 (3,950) (7,900) (19,750) (830) (1,659) (4,148) (1,150) (1,150) (1,240) (1,240) 731 (153) 577 3,851 (809) 3,042 (1,150) (1,240) 13,213 (2,775) 10,438 Notes: 1. Capital expenditure: $8 million for new machinery and $2.5 million for a warehouse extension. The full cost of the extension has been charged to this project, although only about half of the space is currently needed. Since the new machinery will be housed in an existing factory building, no charge has been made for land and building which has a book value of $3.8 million ($1.8 million building; $2 million land) and originally cost $7.5 million ($6 million to building; $1.5 million to land). The building is being depreciated at a rate of $300,000 per year to a zero value. Reliable recently received an offer of $10 million for the land and building, and expects it to be worth $12 million at the end of 2028 when the building will have $0 book value. The value of the land has not and is not expected to change form its purchase price of $2 million. The machinery is expected to have a scrap value of $500,000 at the end of 10 years; the warehouse is expected to be worth $1 million at the end of the project. Research and development: $1.82million spent in 2018. This figure was adjusted for inflation since the time of the expenditure to date. Thus. $1.82 million x 1.1 = $2 million. 3. Working capital: Initial investment in inventories. Reliable expects accounts receivable to average 20% of sales and it expects accounts payable to average 15% of operating expenses. 2. 3. Working capital: Initial investment in inventories. Reliable expects accounts receivable to average 20% of sales and it expects accounts payable to average 15% of operating expenses. 4. Revenue: These figures assume sales of 2,000 motors in 2020, 4,000 in 2021, and 10,000 per year from 2022 through 2029, The initial unit price of $3,950 is forecasted to remain constant in real terms, 5. Operating costs: These costs include all direct and indirect costs. Indirect costs (heat, light, power, fringe benefits, etc.) are assumed to be 200% of direct labor costs. Operating costs per unit are forecasted to remain constant in real terms at $2,000. 6. Overhead: Marketing and administrative costs, assumed equal to 10% of revenue. 7. Depreciation: Straight-line for 10 years. 8. Interest: Charged on capital expenditures and working capital at Reliable current borrowing rate of 8%. Income: Revenue less the sum of research and development, operating costs, overhead, depreciation, and interest. 9. 10. Tax: 21% income. However, project income is negative in 2019. In 2019, Reliable expects to have taxable income in excess of the project's loss. 11. Net cash flow: Assumed equal to income less tax. 12. Net present value: NPV of net cash flow at a 15% discount rate. 2. Cash flows Reliable Electric, a major Ruritanian producer of electrical products, is considering a proposal to manufacture a new type of industrial electric motor that would replace most of its existing product line. A research breakthrough has given Reliable a two- year lead on its competitors. The project is not expected to be viable for more than ten years. The project proposal is summarized in the table below. a. Read the notes to the table carefully. Which entries make sense? Which do not? Why or why not? b. What additional information would you need to construct a version of the table that makes sense? c. Construct such a table and recalculate NPV. Explicitly state any additional assumptions you find necessary. (1) Capital expenditure (2) Research and development (3) Working capital (4) Revenue (5) Operating costs (6) Overhead (7) Depreciation (8) Interest (9) Income (10) Tax @21% (11) Net cash flow (12) Net present value 2019 (11,500) (2,000) 4,000 (2,000) (17,500) 20,719 2020 2021 2022-2029 7,900 15,800 39,500 (3,950) (7,900) (19,750) (830) (1,659) (4,148) (1,150) (1,150) (1,240) (1,240) 731 (153) 577 3,851 (809) 3,042 (1,150) (1,240) 13,213 (2,775) 10,438 Notes: 1. Capital expenditure: $8 million for new machinery and $2.5 million for a warehouse extension. The full cost of the extension has been charged to this project, although only about half of the space is currently needed. Since the new machinery will be housed in an existing factory building, no charge has been made for land and building which has a book value of $3.8 million ($1.8 million building; $2 million land) and originally cost $7.5 million ($6 million to building; $1.5 million to land). The building is being depreciated at a rate of $300,000 per year to a zero value. Reliable recently received an offer of $10 million for the land and building, and expects it to be worth $12 million at the end of 2028 when the building will have $0 book value. The value of the land has not and is not expected to change form its purchase price of $2 million. The machinery is expected to have a scrap value of $500,000 at the end of 10 years; the warehouse is expected to be worth $1 million at the end of the project. Research and development: $1.82million spent in 2018. This figure was adjusted for inflation since the time of the expenditure to date. Thus. $1.82 million x 1.1 = $2 million. 3. Working capital: Initial investment in inventories. Reliable expects accounts receivable to average 20% of sales and it expects accounts payable to average 15% of operating expenses. 2. 3. Working capital: Initial investment in inventories. Reliable expects accounts receivable to average 20% of sales and it expects accounts payable to average 15% of operating expenses. 4. Revenue: These figures assume sales of 2,000 motors in 2020, 4,000 in 2021, and 10,000 per year from 2022 through 2029, The initial unit price of $3,950 is forecasted to remain constant in real terms, 5. Operating costs: These costs include all direct and indirect costs. Indirect costs (heat, light, power, fringe benefits, etc.) are assumed to be 200% of direct labor costs. Operating costs per unit are forecasted to remain constant in real terms at $2,000. 6. Overhead: Marketing and administrative costs, assumed equal to 10% of revenue. 7. Depreciation: Straight-line for 10 years. 8. Interest: Charged on capital expenditures and working capital at Reliable current borrowing rate of 8%. Income: Revenue less the sum of research and development, operating costs, overhead, depreciation, and interest. 9. 10. Tax: 21% income. However, project income is negative in 2019. In 2019, Reliable expects to have taxable income in excess of the project's loss. 11. Net cash flow: Assumed equal to income less tax. 12. Net present value: NPV of net cash flow at a 15% discount rate.

Answer rating: 100% (QA)

a The entries that make sense are 2019 Capital expenditure 8 million for new machinery and 25 million for a warehouse extension Research and development 182 million spent in 2018 This figure was adjus... View the full answer