Payback Period, ARR, and NPV. The Baxter Company manufactures toys and shortlived-fad-type items. The research and development department came up with an item that would make a good promotion gift for office equipment dealers. Aggressive and effective effort by Baxter’s sales personnel has resulted in almost firm commitments for this product for the next 3 years. It is expected that the product’s value will be exhausted by that time.
In order to produce the quality demanded Baxter will need to buy additional machinery and rent some additional space. It appears that about 25,000 square feet will be needed: 12,500 square feet of presently unused, but leased, space is available now. (Baxter’s present lease with 10 years to run costs $3.00 a square foot.) There is another 12,500 square feet adjoining the Baxter facility which Baxter will rent for 3 years at $4.00 per square foot per year if it decides to make this product.
The equipment will be purchased for about $900,000. It will require $30,000 in modifications, $60,000 for installation, and $90,000 for testing: all of these activities will be done by a firm of engineers hired by Baxter. All of the expenditures will be paid for on January 1, 20X1.
The equipment should have a salvage value of about $180,000 at the end of the third year. No additional general overhead costs are expected to be incurred.
The following estimates of revenues and expenses for this product for the 3 years have been developed.
20X1 20X2 20X3
Sales $1,000,000 $1,600,000 $800,000
Material, labor, and incurred overhead $ 400,000 $ 750,000 $350,000
Assigned general overhead 40,000 75,000 35,000
Rent 87,500 87,500 87,500
Depreciation 450,000 300,000 150,000
$ 977,500 $1,212,500 $622,500
Income before tax $ 22,500 $ 387,500 $117,500
Income tax (40%) 9,000 155,000 71,000
$ 13,500 $ 232,500 $106,500
1. Prepare a schedule which shows the incremental after-tax cash flows for this project.
2. If the company requires a 2-year payback period for its investment, would it undertake this project? Show your supporting calculations clearly.
3. Calculate the after-tax accounting rate of return for the project.
4. A newly hired business-school graduate recommends that the company consider the use of net present value analysis to study this project. If the company sets a required rate of return of 20 percent after taxes, will this project be accepted? Show your supporting calculations clearly. (Assume all operating revenues and expenses occur at the end of the year.)