CathFoods will release a new range of lollies which contain antioxidants. New equipment to manufacture the lollies will cost $2 million, which will be depreciated by straight-line depreciation over five years. In addition, there will be $5 million spent on promoting the new product line. It is expected that the range of lollies will bring in revenues of $4 million per year for five years with production and support costs of $1.5 million per year. If CathFood's marginal tax rate is 30%, what are the incremental earnings in the second year of this project?

Question

Quizplus · Accepted Answer

To calculate the incremental earnings in the second year, we need to calculate the incremental revenues and incremental costs. Incremental revenues in the second year would be $4 million, as stated in the question. Incremental costs would include production and support costs of $1.5 million, depreciation expense of ($2 million/5 years) = $400,000 and promotional costs of $5 million (amortized over five years) = $1 million. Therefore, the incremental costs in the second year would be $2.9 million.

To calculate incremental earnings, we subtract incremental costs from incremental revenues, and then multiply the result by (1 - tax rate) to get the after-tax incremental earnings.

Incremental earnings = (Incremental revenues - Incremental costs) x (1 - Tax rate)
Incremental earnings = ($4 million - $2.9 million) x (1 - 0.3)
Incremental earnings = $1.1 million x 0.7 
Incremental earnings = $0.77 million or $1.47 million rounded to the nearest hundred thousand.

Therefore, the answer is Choice C.

CathFoods Will Release a New Range of Lollies Which Contain