Unilate Textiles is evaluating a new product, a silk/wool blended fabric. Assume you were recently...

Question

Unilate Textiles is evaluating a new product, a silk/wool blended fabric. Assume 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 Unilate's 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, and 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 depredated under the MACRS system as 3-year class property. (See Table 10A-2 at the end of this chapter 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 project's 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 excluding depreciation) are expected to total 60 percent of dollar sales. Unilate's marginal tax rate is 40 percent, and its required rate of return is 10 percent. Tentatively, the silk/wool blend fabric project is assumed to be of equal risk to Unilate's 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 tat to complete:

a. 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.

b. Unilate has a standard form that is used in the capital budgeting process; see Table IP10-1. Part of the table has been completed, but you must fill in the blanks. Complete the table in the following order:

(1) Complete the unit sales, sales price, total revenues, and operating costs excluding depredation lines. (2) Complete the depreciation line.

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

(4) Now fill in the blanks under Year 0 and Year 4 for the initial investment outlay and the terminal cash flows and complete the cash flow time line (net CF). Discuss working capital What would have happened if the machinery were sold for less than its book value?

c. (1) Unilate uses debt in its capital structure, so some of the money used to finance the project will be debt Given this fact, should the projected cash flows be revised to show projected interest charges? Explain.

(2) Suppose you learned that Unilate had spent $50,000 to renovate the building last year, expensing these costs. Should this cost be reflected in the analysis? Explain.

(3) Now suppose you learned that Unilate could lease its building to another party and earn $25,000 per year. Should this fact be reflected in the analysis? If so, how?

(4) Now assume that the silk/wool blend fabric project would take away profitable sales from Unilate's cotton/wool blend fabric business. Should this fact be reflected in your analysis? If so, how?

d. Disregard all the assumptions made in part c, and assume there was no alternative use for the building over the next four years. Now calculate the project's NPV, IRR, and traditional payback. Do these indicators suggest that the project should be accepted?

e. If this project had been a replacement project rather than an expansion project, how would the analysis have changed? No calculations are needed; just think about the changes that would have to occur in the cash flow table.

f. Assume that inflation is expected to average 3 percent over the next four years, that this expectation is reflected in the required rate of return, and that inflation will increase variable costs and revenues by the same relative amount of 3 percent. Does it appear that inflation has been dealt with properly in the analysis? If not, what should be done, and how would the required adjustment affect the decision?

David · Accepted Answer

1 
a) 
You might want to begin discussion differentiating between cash flow versus accounting income.  
              0     1 2 3 4
Cash flow time lines are helpful for showing where cash flows occur. When the data are developed and 
numbers have been put on the time line, it facilitates inputting the cash flows into a calculator to calculate 
the NPV, IRR, and payback.
b) 
1) 
ANSWER: This answer requires no explanation. Students might note, though, that inflation is not 
reflected at this point. It will be later. The top part of the income statement is:
      Table IP7-1, Unilate’s Silk/Wool Blend Fabric Project ($ thousands)
              End of Year:            1         2        3        4  
      Unit sales (thousands)                     100       100      100      100 
      Price/unit                     $2.00     $2.00    $2.00    $2.00
        Total revenues                        $200.0    $200.0   $200.0   $200.0 
      Costs excluding depreciation            (120.0)   (120.0)  (120.0)  (120.0)
b) 
2) 
ANSWER:  The only thing that requires explanation here is the use of the depreciation tables in Appendix 
7A. Here are the rates for 3-year property; they are multiplied by the depreciable basis, $240,000, to get 
the annual depreciation allowances ($ thousands):
  Year 1  0.33  x $240  = $ 79.2 
  Year 2   0.45  x  240  =   108.0 
^
1CF
^
2CF
^
3CF
^
4CF
k%
2 
  Year 3    0.15  x  240  =    36.0 
  Year 4   0.07  x  240  =    16.8 
             1.00   $240.0
b) 
3) 
ANSWER:  This is straightforward. The only even slightly complicated thing is adding back depreciation 
to get net CF.
         Table IP7-1, Unilate’s Silk/Wool Blend Fabric Project ($ thousands)
              End of Year:            0 1         2        3        4  
      Unit sales (thousands)                     100       100      100      100 
 Price/unit                        $2.00      $2.00     $2.00     $2.00     $2.00
 Total revenues                        $200.0    $200.0    $200.0    $200.0 
 Costs excluding depreciation               (120.0)   (120.0)   (120.0)   (120.0) 
 Depreciation                                (  79.2)   (108.0)   ( 36.0)   ( 16.8) 
 Total operating costs                     (199.2)   (228.0)   (156.0)   (136.8)  
 Earnings before taxes (EBT)                0.8   (   8.0)   $ 44.0    $ 63.2 
 Taxes                                     (    0.3)     11.2    ( 17.6)   ( 25.3) 
 Net income                                $  0.5   $( 16.8)   $ 26.4    $ 37.9 
 Depreciation                                  79.2     108.0      36.0      16.8 
 Incremental operating CF                  $ 79.7   $  91.2   $ 62.4    $ 54.7
3 
b) 
4) 
ANSWER:  These are all straightforward. Note that accounts payable is an offset to the inventory 
buildup, so the net working capital requirement is $20,000, which is recovered at the end of Year 4. Also, 
the salvage value is fully taxable, because the asset has been depreciated to a zero book value.

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

Answer To: Unilate Textiles is evaluating a new product, a silk/wool blended fabric. Assume you were recently...

Answer To This Question Is Available To Download

Related Questions & Answers

Submit New Assignment