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Making Capital Investment Decisions: Korry Materials

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You must analyze a potential new product -- a caulking compound that Korry Materials' R&D people developed for use in the residential construction industry. Korry's marketing manager thinks they can sell 115,000 tubes per year at a price of $3.25 each for 3 years, after which the product will be obsolete. The required equipment would cost $125,000, plus another $25,000 for shipping and installation. Current assets (receivables and inventories) would increase by $35,000, while current liabilities (accounts payable and accruals) would rise by $15,000. Variable costs would be 60% of sales revenue, fixed costs (exclusive of depreciation) would be $70,000 per year, and fixed assets would be depreciated under MACRS with a 3 year life. When production ceases after 3 years, the equipment should have a market value of $15,000. Korry's tax rate is 40%, and it uses a 10% WACC for average risk projects.

The R&D costs for the new product were $30,000, and those costs were incurred and expensed for tax purposes last year. If Korry Materials accepts the new project it will result in an annual loss of revenue on an existing product of $5,000.

Find the required year 0 investment, the annual after-tax operating cash flow, and the terminal year cash flow. Assuming the project is of average risk, calculate the project's NPV, IRR, MIRR, and payback period.

Solution Preview

Equipment $125,000+$25,000 = $150,000
Net working capital $35,000-$15,000 = $20,000
Required Year 0 investment = $150,000+$20,000 = $170,000

MACRS Depreciation
Year 1 = $150,000 x 33.33% = $49,995
Year 2 = $150,000 x 44.45% = $66,675
Year 3 = $150,000 x 14.81% = $22,215
Year 4 = $150,000 x 7.41% = $11,115

Revenues 115,000 x $3.25 =$373,750
Annual loss of revenue on existing products -$5,000
Variable costs $373,750 x 60% = $224,250
Fixed costs $70,000
Depreciation costs $49,995
Operating income before tax $373,750-$5,000-$224,250-$70,000-$49,995 = $24,505
Income tax $24,595 x 40% = $9,802
Operating profit $24,505-$9,802 = $14,703
Year 1 Annual after-tax operating cash flow = $14,703+$49,995 = $64,698

Revenues 115,000 x $3.25 ...

Solution Summary

This solution assists with decisions regarding capital investments for Korry Materials.

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