Integrative Problem 10-1

Unilate Textiles is evaluating a new product, a silk/wool blended fabric. Assume that you were recently hired as assistant to the director of capital budgeting, and you must evaluate the new project.

The fabric would be produced in an unused building adjacent to Unilates Southern Pines, North Carolina plant. Unilate 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, inventories would rise by $25,000, while accounts payable would go up by $5,000. All of these costs would be incurred at Year 0. By a special ruling, the machinery could be depreciated under the MACRS system as 3-year property. (See Table 10A.2 at the end of Chapter 10 for MACRS recovery allowance percentages.)

The project is expected to operate for four years, at which time it will be terminated. The cash inflows are assumed to begin one year after the project is undertaken, or at t = 1, and to continue out to t = 4. At the end of the projects life (Year 4), the equipment is expected to have a salvage value of $25,000.

Unit sales are expected to total 100,000 five-yard textile rolls per year, and the expected sales price is $2 per roll. Cash operating costs for the project (total operating costs less depreciation) are expected to total 60% of dollar sales. Unilates marginal tax rate is 40%, and its required rate of return is 10%. Tentatively, the silk/wool blend fabric project is assumed to be of equal risk to Unilates other assets.

You have been asked to evaluate the project and to make a recommendation as to whether it should be accepted or rejected. To guide you in your analysis, your boss gave you the following set of tasks to complete:

Draw a cash flow time line that shows when the net cash inflows and outflows will occur, and explain how the time line can be used to help structure the analysis.

Unilate has a standard form that is used in the capital budgeting process and shown in the following table:

Unilates Silk/Wool Fabric Project ($ Thousands)

End of Year: 0 1 2 3 4

Unit sales (Thousands) 100

Price/unit $ 2.00 $ 2.00

Total revenues $200.0

Costs excluding depreciation ($120.0)

Depreciation ( 36.0) ( 16.8)

Total operating costs ($199.2) ($228.0)

Earnings before taxes (EBT) $44.0

Taxes ( 0.3) 25.3

Net income $26.4

Depreciation 79.2 36.0

Supplemental operating CF $ 79.7 $ 54.7

Equipment cost

Installation

Increase in inventory

Increase in accounts payable

Salvage value

Tax on salvage value

Return of net working capital

Cash flow timeline (net CF): ($260.0) $ 89.7

Cumulative CF for payback: ( 260.0) ( 180.3) 63.0

NPV =

IRR =

Payback =

Complete the table in the following order:

Complete the unit sales, sales price, total revenues, and operating costs excluding depreciation lines.

Complete the depreciation line.

Now complete the table down to net income and then down to net operating cash flows.

What are the advantages and disadvantages of focusing on a projects market risk?