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Should Seals produce the cold rooms?
Seals Co.taxable company with overseas shareholders, has recently completed a $400,000, 2 year marketing study. Based on the results, Seals has estimated that 10,000 of its new cold rooms could be sold annually over the next eight years at a price of $9,615 each. Subcontractors would install the cold rooms at a cost per installation of $7,400. Fixed costs to be incurred would be $12 million per year.
Start up costs include $40 million to build production facilities and $2.4 million in land. The $40 million facility will be depreciated prime cost to zero over the project's life. At the end of the project's life the facilities (including the land) will be sold for an estimated $8.4 million. The value of the land is not expected to change.
Finally, at start-up working capital would need to be increased by $1.4 million. Seals is an ongoing profitable business and pays taxes at a 30% rate in the year of income on all income and gains. Seals use a 10% discount rate on projects such as this one.
Should Seals produce the cold rooms?
Replies are closed for this discussion.
Replies to This Discussion
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Permalink Reply by Kaustubh Shrotriya on -
Initial cash outflow is 40mm + 2.4mm + 1.4mm = 43.8mm. $400000 spent on marketing study is a sunk cost and hence irrelevant for this decison making.
annual depreciation = [40mm - (8.4-2.4) ]/8 = 4.25. cost of land is excluded from residual value.
Annual Profit before tax = 10000* (9615-7400) - 12mm (fixed cost) - 5 mm (depreciation = 5.9mm
Annual Profit after tax = 5.9mm - tax (30% of 5.9mm) = 4.13mm
Annual cash inflow = annual profit after tax + depreciation = 4.13mm + 4.25mm = 8.38mm
In the eight year, the additional cashflow = 8.4mm (residual value of facility)+ 1.4mm (recovery of working capital)
discounting at 10% gives the net present value of the project as 9.27mm. Since the Net present value of ashflows generated by the project is positive, the PROJECT SHALL be ACCEPTED.
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Permalink Reply by George A.Y. on -
No problem in initial cash outlay but:
1. Land is $2.4 mm which should not be "depreciated".
2. "The $40 million facility will be depreciated prime cost to zero over the project's life"
3. Depreciation brings no CF directly except its tax shield.
So the CF from year 1 to 7 should be :
= [10000* (9615-7400) - 12mm (fixed cost)]*(1-0.3) + 5*0.3
= 8.605 mm
When the business is closed, the asset sold should be taxed for any capital gain.
Assume
1. the firm still exists and hence can realize the "tax reduction due to capital loss" (I forgot the term used to describe that... sorry for that),
2. the operation of the project is not affected by the close-down (or u can assume whole equipment will be sold in the blink of eye... XD)
CF at the end of year 8 should be :
= 8.605 + 8.4 + 34*0.3 = 27.205 mm
NPV @ 10% = 10.7841... Green light to that.
just my 2 cents. forgive my mistakes XD
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Permalink Reply by Angus T. C. Wong on
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Is the 7.4k per cold room a setup cost (Installation cost) or an annual operating cost? I believe the operating cost is already included in the 12M Fixed Cost.
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Permalink Reply by Matt W. on -
I had one input for the terminal cash flow: "$40 million facility will be depreciated prime cost to zero over the project's life" would mean that the capital gain would be 8.4mm (the sales price of the fully depreciated facility and the non-depreciable land) less the 2.4mm ("The value of the land is not expected to change"). Then you would take out taxes and add that amount to the operating cash flow portion.
numeric: (8.4mm - 2.4mm) * (1-30%)
I guess I am getting lost with the 34*.3 number in George's arithmetic.
At least that is my understanding of this problem. Does this sound correct to everyone else?
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Permalink Reply by RGroenendal on -
I agree with George A.Y. up to the 34*.3......I don't understand where the 34 is coming from either and agree with your numeric calculation Matt.
But taking this into account the outcome for this project still looks positive to me.
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Permalink Reply by Krishnan Mak on -
Yes, Seals should produce the cold rooms.
Plz refer to working attached. - Attachments:
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Permalink Reply by N.Gopikrishnan on -
i do agree with the proposal .Pls see workings and guide me for any lapses
Thanks - Attachments:
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SEALS COMPANY.xlsx, 21 KB
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Permalink Reply by Sherif Rabie on
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My calculations match yours except for:
the working capital addition of 1.4M US$ shouldn't be depreciated as this is a cash injection to cover cashflow deficit and wouldn't appear in the income statement.
in the NPV formula you shouldn't discount the initial investment (40+2.4+1.4+0.4) by 10% as this is at the start of the project.
My calculation show an NPV of $451,298 though I didn't take into account the marketing cost as I agree that it is a sunk cost.
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Permalink Reply by RGroenendal on
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Hi Krishnan, you did not take into account the neccesary increase of working capital. Can you indicate how you handled this ?
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Permalink Reply by Peter Quigley on -
Hello Krishnan
1) I was wondering if you explain why the cost increase in working capital of 1.4m has been added to your Y9 cash flow [ 8.4 m less (2.52m of tax) to give 5.88 plus 1.4m =7.28m]?
2) The figure in cell M17. Can you clarify how you arrived at this please?
Thanks in advance and Best Regards
Peter
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Permalink Reply by George A.Y. on
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Sorry for confusing others abt my calculation.
When the project terminates at year 8, the equipment will be sold. The capital gain will be taxed.
But this case it has a capital loss (obviously).
Recall "At the end of the project's life the facilities (including the land) will be sold for an estimated $8.4 million. The value of the land is not expected to change."
Then book value of the equipment at year 8 will be $6 mm (8.4 - 2.4).
Capital loss = $(40 - 6) = $34 mm
Again, similar to depreciation, the capital loss doesn't result in any CF but in "tax shield".
The corresponding tax shield will be 34*0.3 mm.
Of course I assume that Seals still exists at year 8 and hence I can include the capital loss in its income statement. Otherwise I agree it will be doubtful if we should include the tax shield.
just my 2 cents.
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Permalink Reply by Sherif Rabie on
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No capital loss. The capital (equipment) itself US$ 40mm is depreciated over the project lift time and has 0 book value by end of Y8, this is resulted in reducing the amount of tax to be paid due to depreciation taken into account in the income statement, hence impacting positively on the cash flow, thus can't recount it twice in calculating the Tax for the Capital gain.
So the The capital gain of 8.4-2.4 is still taxable 6mm *0.3.
Project is still a green light.
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