I’m working on a business question and need an explanation to help me understand better.
Chrysarbor Textiles is evaluating a new product, a silk / wool blend fabric. Let’s say you were recently hired as an assistant to the capital budgeting director, and you need to evaluate the new project.
The fabric would be produced in an unused building adjacent to Chrysarbor’s Hryory, North Carolina plant. Chrysarbor owns the building, which is fully depreciated. The required equipment would cost $ 200,000, plus an additional $ 40,000 for shipping and installation. Additionally, inventories would increase by $ 25,000, while accounts payable would increase by $ 5,000. All of these costs would be incurred in year 0. Through a special resolution, the machinery could be depreciated under the MACRS system as a 3-year property. (See Table 10A.2 at the end of Chapter 10 for MACRS recovery bonus percentages.)
The project is expected to run for four years, at which point it will be terminated. Cash inflows are assumed to start one year after the project is carried out, or at t = 1, and continue until t = 4. At the end of the project life (year 4), the team is expected to have a salvage value of $ 25,000.
Unit sales are expected to total 100,000 rolls of five-yard textiles per year, and the expected selling price is $ 2 per roll. Cash operating costs for the project (total operating costs less depreciation) are expected to total 60% of sales in dollars. Chrysarbor’s 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 Chrysarbor’s other assets.
You have been asked to evaluate the project and make a recommendation on whether it should be accepted or rejected. Your supervisor, Mr. Greg Ward, gave you the following set of tasks to complete:
to. Draw a cash flow timeline showing when the net cash inflows and outflows will occur, and explain how the timeline can be used to help structure the analysis.
b. Chrysarbor has a standard form that is used in the capital budgeting process and is shown in the following table:
Chrysarbor Silk / Wool Fabric Project (in thousands of dollars)
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
Increase in inventory
Increase in accounts payable
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 = Net Present Value?
IRR = Internal Rate of Return?
Payback = Payback period?
Complete the table in the following order:
(1) Fill in unit sales, sales price, total revenue, and operating costs, excluding depreciation lines.
(2) Complete the depreciation line.
(3) Now fill in the table to net income and then to net operating cash flows.
(4) Now fill in the blanks under Year 0 and Year 4 for initial investment outlay and terminal cash flows and fill in the cash flow timeline (net CF). Discuss the working capital. What if the machinery had been sold for less than its book value?
(1) Chrysarbor uses debt in its capital structure, so part of the money used to finance the project will be debt. Given this fact, should projected cash flows be revised to show projected interest charges? Explain.
(2) Suppose you learned that Chrysarbor spent $ 50,000 to renovate the building last year, which incurred expenses. Should this cost be reflected in the analysis? Explain.
(3) Now suppose you learned that Chrysarbor could lease its building elsewhere and earn $ 25,000 per year. Should this fact be reflected in the analysis? If so, how?
(4) Now suppose that the silk / wool blend project would eliminate profitable sales from Chrysarbor’s wool and cotton blend business. Should this fact be reflected in your analysis? If so, how?