Question
STC & Tweety, LLP own and operate a canary breeding farm. For the most recent year, STC & Tweety generated revenues of $250,000, incurred operating
STC & Tweety, LLP own and operate a canary breeding farm. For the most recent year, STC &
Tweety generated revenues of $250,000, incurred operating costs of $120,000, and had an after-tax net income of $77,000.
STC & Tweety are considering replacing their canary breeding barn. The current (old)
breeding barn has a book value of $60,000 and could be sold today for $45,000. Alternatively,
the current barn could be used for the next 3 years, after which if could be sold for
$3,000.
If STC & Tweety decide to keep using the old barn then they anticipate spending $10,000
to fix (repair) the barn at the end of the first year. These costs are considered a routine
maintenance expense and will not increase the barns book value.
A new canary barn would cost $180,000, but it would save STC & Tweety $70,000 in before-
tax operating costs for each of the next three years. Additionally, after the third year
STC & Tweety could sell the new barn to a local farmer for $5,000.
STC & Tweety depreciate all of their assets using straight-line depreciation and zero assumed
salvage value. Their required rate of return (cost of capital) is 10%, and their tax
rate is 30%.
Assume all operating cash flows occur at year end.
Required:
a. Define the status quo.
b. Define the alternative.
c. What is the incremental initial after-tax cash outflow associated with the alternative
you have defined? Be sure to include all relevant cash flows.
d. What is the alternatives incremental after-tax cash inflow for the end of year two?
e. Draw a timeline that shows all of the incremental cash flows associated with the alternative
you have defined.
f. Should STC & Tweety, LLP invest in the new barn?
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