Big Muzz Motors manufactures a line of traditional (two wheel) motor cycles. Given the recent success of
Question:
Big Muzz Motors manufactures a line of traditional (two wheel) motor cycles. Given the recent success of "moto-cars" like the Polaris slingshot, management is considering a new business proposal to produce a line of aggressive 3-wheeled motorcycles. Estimates of the cost and benefits include the following information:
CAPEX: Cost of new production equipment and machinery including freight and setup $2,000,000 with a 5 year life (assume straight line depreciation applies)
Onetime expense of hiring and training new employees pre-startup $125,000
Pre-start-up one-time advertising and other miscellaneous (non-CAPEX) expenses $75,000
Initial inventory required to service sales is $150,000; it has to be in place before operations start (so in time-period 0) and does not vary over the life of the project, except for being sold off at the end of the project. This is the only working capital for this project.
Sales are forecast to be 125 units the first year and will grow 35% in the second year and 20% in the third.
Sales Price: $24,000 / unit
Unit cost to manufacture (60% of revenue): $14,400
Buzz Motors further has additional selling and administrative expense per year that depend on sales: Each additional dollar of sales increases Sales & Admin Expenses by 12 cents (regardless of whether they are 3- or 2-wheelers).
If Big Muzz does this project to make three-wheeled car alternatives they expect to lose some of their current motorcycle sales to the new product. Ten percent of the new unit forecast is expected to come out of sales that would have gone to the old line of motorcyles (e.g. someone comes in to buy a motorcycle but sees the new product and decides to buy one of them instead). You need to assume that prices and profit margins are identical for both product lines.
Make sure that you remember that this project is part of an existing company, and so any potential tax savings on losses could be used to offset taxes on other lines of business. In other words, you may assume that tax savings can be fully absorbed in the year they are incurred (even if its in a year where this specific project has zero revenue)Big Muzz has a 35% tax rate and wants to estimate the cash flows of this project over the next 3 years. Hence the time-periods we want to model are 0 (pre-startup), 1, 2, and 3. Assume that the initial inventory is liquidated at its book value at the end of three years; and that the new equipment purchased today (at time-period 0) is sold/liquidated at its book value at the end of year 3. (All cash flows occur end-of-year). The relevant discount rate/cost-of-capital for this project is 12%.
Determine the free cash flows for this investment project.
What is the most you should pay for the new equipment and machinery? In other words what is the purchase price of the new equipment that makes this a a break-even ($0 NPV) project? Write down the answer in your excel spreadsheet, but make sure to keep the initial value the same (2,000,000).
Management Accounting Information for Decision-Making and Strategy Execution
ISBN: 978-0137024971
6th Edition
Authors: Anthony A. Atkinson, Robert S. Kaplan, Ella Mae Matsumura, S. Mark Young