Chrysarbor Textiles is evaluating a new product, a silk/woolblended fabric. Assume that you were recently hired as assistant tothe director of capital budgeting, and you must evaluate the newproject.
The fabric would be produced in anunused building adjacent to Chrysarborâs Hickory, North Carolinaplant. Chrysarbor owns the building, which is fully depreciated.The required equipment would cost $200,000, plus an additional$40,000 for shipping and installation. In addition, inventorieswould rise by $25,000, while accounts payable would go up by$5,000. All of these costs would be incurred at Year 0. By aspecial ruling, the machinery could be depreciated under the MACRSsystem as 3-year property. (See Table 10A.2 at the end of Chapter10 for MACRS recovery allowance percentages.)
The project is expected to operate for four years, at which timeit will be terminated. The cash inflows are assumed to begin oneyear after the project is undertaken, or at t = 1, and to continueout to t = 4. At the end of the projectâs life (Year 4), theequipment is expected to have a salvage value of $25,000.
Unit sales are expected to total 100,000 five-yard textile rollsper year, and the expected sales price is $2 per roll. Cashoperating costs for the project (total operating costs lessdepreciation) are expected to total 60% of dollar sales.Chrysarborâs marginal tax rate is 40%, and its required rate ofreturn is 10%. Tentatively, the silk/wool blend fabric project isassumed to be of equal risk to Chrysarborâs other assets.
You have been asked to evaluate the project and to make arecommendation as to whether it should be accepted or rejected.Your supervisor, Mr. Greg Ward, gave you the followingset of tasks to complete:
- Draw a cash flow time line that shows when the net cash inflowsand outflows will occur, and explain how the time line can be usedto help structure the analysis.
- Chrysarbor has a standard form that is used in the capitalbudgeting process and shown in the following table:
End ofYear: 0 1 2 3 4
Unit sales (Thousands)100
Price/unit $2.00 $ 2.00
Totalrevenues $200.0
Costs excludingdepreciation ($120.0)
Depreciation ( 36.0) ( 16.8)
Total operatingcosts ($199.2) ($228.0)
Earnings beforetaxes(EBT) $44.0
Taxes ( 0.3) 25.3
Netincome $26.4
Depreciation 79.2 36.0
SupplementaloperatingCF $79.7 $54.7
Equipment cost
Installation
Increase in inventory
Increase in accountspayable
Salvage value
Tax on salvage value
Return of net workingcapital
Cash flow timeline (netCF): ($260.0) $89.7
Cumulative CF forpayback: (260.0) (180.3) 63.0
NPV=
IRR=
Payback=
Complete the table in the followingorder:
- Complete the unit sales, sales price, total revenues, andoperating costs excluding depreciation lines.
- Complete the depreciation line.
- Now complete the table down to net income and then down to netoperating cash flows.
- Now fill in the blanks under Year 0 and Year 4 for the initialinvestment outlay and the terminal cash flows and complete the cashflow time line (net CF). Discuss working capital. What would havehappened if the machinery were sold for less than its bookvalue?
- (1) Chrysarbor uses debt in its capitalstructure, so some of the money used to finance the project will bedebt. Given this fact, should the projected cash flows be revisedto show projected interest charges? Explain.
(2) Suppose you learned that Chrysarbor had spent $50,000 torenovate the building last year,
