If the Coat Fits Wear It

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Solution to Case 103

IF THE COAT FITS WEAR IT – TEACHING NOTE

Questions
1.Your supervisor, Vic Gonzales, has asked you to prepare a capital budgeting report indicating whether ISGC should replace the existing machine or not. Indicate how would you proceed (without making any calculations)?

I would estimate the incremental cash flows over the economic life of the new machine, taking into consideration the after-tax salvage values of the old and new machine respectively. Changes in net working capital would be figured in as well. For the terminal year, we would assume that the net working capital is recovered and treat it as a cash inflow.

2.Explain the relevance of incremental cash flows, sunk costs, and incidental costs in the context of this case. Since this case involves the decision of whether or not to replace an existing machine, it is important to take into consideration only the difference between the various revenue and expense items that would occur if the old machine were replaced. These are called incremental cash flows. Sunk costs are not relevant in this case. An example of a sunk cost would be a consulting fee paid by the firm to come up with suggestions regarding output efficiency. Incidental costs are those that affect some other area or aspect of the firm’s business. For example, if as a result of the new machine, sales of some other product of the company suffered, the reduced revenues should be considered as a cash outflow for the new project.

3.As is often the case, the marketing department has overestimated the annual sales growth. How can more conservative and realistic estimates be generated? How can these estimates be incorporated into the analysis so as to arrive at a good and well-justified decision?

The marketing department’s sales forecast is a good place to start. However, it is better for managers to consider the overall market for baseball bats and accordingly estimate their niche. Also, various scenarios of growth (best case, worst case, and most likely case) could be used to estimate the pro forma financial statements and analyze them using the various evaluation techniques.

4.What are the relevant factors and items to be considered when estimating the initial outlay? Calculate the initial outlay for this replacement project.

For the initial outlay, the cost of the new machine (including shipping, handling, and installation), and the change in net working capital (change in current assets less change in current liabilities) are the usual cash outflows involved. Cash inflows would include the after-tax selling price of the old machine. If the old machine is sold for more than its book value, there is a taxable gain and vice-versa. In the current case the initial outlay is as follows:

Price of new machine……………………….. $350,000
Shipping, Handling, Installation…………….. $ 4,500
Change in Net Working Capital
Increase in receivables$54,000
Increase in inventory$20,000
Increase in payables($30,000)
$44,000
Total Cash Outflow……………………………$398,500

Cash Inflows at t = 0
Selling Price of old machine100,000
Tax shield on Loss @ 34% 17,000
After-tax salvage value117,000

Loss on sale = Book Value – Market Value
Where BV = 225,000 – 5*Depreciation = 225,000 - (5*15,000) = 150,000 Loss = 225,000 - 150,000 = 50,000

Initial outlay = 398,500 – 117,000 = $281,500

5.How are the interim cash flows to be computed for the productive life of the new machinery? How is depreciation to be accounted for?

The interim cash flows are computed as follows:

(Operating Cash Flow) +/- (Change in Net working capital) +/- (Capital spending)

OCF = (Incremental sales – Incremental costs (other than interest) – Depreciation)*(1-tax rate) + Depreciation = EBIT – Taxes + Depreciation

Depreciation is accounted for as an annual charge against income and provides a tax...
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