This exercise parallels the machine-purchase decision for the Mendoza Company that is discussed in the body of the chapter. Assume that Mendoza is exploring whether to enter a complementary line of business. The existing business line generates annual cash revenues of approximately $5,000,000 and cash expenses of $3,600,000, one-third of which are labor costs. The current level of investment in this existing division is $12,000,000. (Sales and costs of this division are not affected by the investment decision regarding the complementary line.)

Mendoza estimates that incremental (non-cash) working capital of $30,000 will be needed to support the new business line. No additional facility-level costs would be needed to support the new line--there is currently sufficient excess capacity. However, the new line would require additional cash expenses (overhead costs) of approximately $400,000 per year. Raw material costs associated with the new line are expected to be $1,200,000, while the total labor cost is expected to double.

The CFO of the company estimates that new machinery costing $2,500,000 would need to be purchased. This machinery has a seven-year useful life and an estimated salvage (terminal) value of $400,000. For tax purposes, assume that the company would use the straight-line method.

Assume, further, that the weighted-average cost of capital (WACC) for Mendoza is 14% (after tax), and that the combined (federal and state) income tax rate is approximately 40%. Finally, assume that the new business line is expected to generate annual cash revenue of $3,600,000.

Data

Existing Business Line:

Annual cash revenues

Annual cash expenes

Portion of cash labor costs

Level of investment

Proposed New Line:

Acquisition cost (time period 0)

Incremental w/c required

Annual cash revenues

Annual cash overhead

Annual raw materials cost

Annual labor cost

Depreciation (straight-line basis):

Original cost of asset (basis)

Estimated salvage (terminal) value

Estimated life (in years)

Income tax rate (federal + state)

Required

1. Determine the relevant (after-tax) cash flow at project initiation.

2. Determine the relevant (after-tax) cash flow each year during project operation.

3. Determine the relevant (after-tax) cash flow at project disposal (termination).

4. Identify any irrelevant costs or revenues associated with this investment proposal.