Question
Baker Company currently has no debt, annual revenues of $1.2 million, and annual costs of $700,000. Depreciation amounts to $200,000 per year. These figures are
Baker Company currently has no debt, annual revenues of $1.2 million, and annual costs of $700,000. Depreciation amounts to $200,000 per year. These figures are expected to remain constant over the next 10 years. Baker is planning to add a new product line to its current operations. Equipment necessary to produce this new product line will cost $1,000,000 and will be depreciated over its 10-year life using straight line depreciation. Interest costs associated with financing the equipment purchase is estimated to be $50,000 per year.
The expected salvage value of the equipment at the end of 10 years is $50,000. The decision to add this new product line will require additional net working capital of $50,000 immediately, $25,000 at the end of year 1, and $10,000 at the end of year 2. Baker expects to sell $300,000 worth of the new product during each of the 10 years of product life. Baker expects the sales of its other products it manufactures to decline by $25,000 (in year one) as a result of adding this new product line. The lost sales level will remain constant at $25,000 over the 10-year life of the new product line. The cost of producing and selling the new product line is estimated to be $50,000 per year. Baker will realize savings of $5,000 each year because of lost sales on its other product lines. Bakers marginal tax rate is 40 percent. Bakers required rate of return is 11 percent.
- If Baker adds this new product line to its existing operations, what are the proper cash flow amounts that will occur over each of the 10-years of production? Show your computations.
- What rate of return will Baker earn by adding this new product line to its existing operations?
- Is Baker justified in adding this new product line to its existing operations? Explain.
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