EXERCISE 4

CHERRY EVALUATES A ZIPPY

You are considering the purchase of a new zippy fabricating machine for your firm, Cherry Enterprises, Inc. CEI makes novelty items for wholesale to retail outlets located in tourist traps. The purchase of the zippy will allow CEI to market a new product, a walking stick with built-in bear repellant. In order to analyze the decisions to manufacture and sell the walking sticks and to lease the zippy, you have collected the following data, some of which may be relevant (all dollars in 2020 prices):

Cost of zippy = $8,500,000

Useful life of zippy = 10 years

Salvage value of zippy = $0

Expected walking stick sales volume (in lots of 1000) = 2500/year

Wholesale price per 1000 lot of walking sticks = $999

Annual zippy maintenance contract costs (no inflation) = $100,000 (only cash fixed cost)

Average variable cost per lot of walking sticks = $500

Additional working capital (supplies inventory) required at beginning of year 1 = $150,000

Current equity = $50,000,000

Current debt = $58,000,000

Tax rate for CEI = 35%

Inflation rate = .03

Zippy can be financed in several ways. The following data pertain to financing options:

Required return on equity (real) = .06

Bank loan interest rate available, given current capital structure = .085

Lease contract with payments made in 10 equal annual installments, beginning at start of

lease period. Lease contract includes maintenance costs. Payment = $1,150,000

Evaluate the zippy as a business opportunity for CEI. Evaluate the lease financing option for the zippy as well. Use the easy way to value a financial lease that is presented in BMA Chapter 25 (p 663). Assume that the change in the tax code in 2017 has expired (as it is claimed to do), we should not be using the tax code changes of 2017, i.e. we should not write off 100% in the first year, but instead spread the depreciation expenses over 10 years using straight line method.. Therefore, spread depreciation expense out over the life of the assetd on a straight-line basis.