Scenario 4.5
The T. H. King Company has introduced a new product line that requires two work centers, A and B for manufacture. Work Center A has a current capacity of 10,000 units per year, and Work Center B is capable of 12,500 units per year. This year (year 0), sales of the new product line are expected to reach 10,000 units. Growth is projected at an additional 1,000 units each year through year 5. Pre-tax profits are expected to be $30 per unit throughout the 5-year planning period. Two alternatives are being considered:
1) Expand both Work Centers A and B at the end of year 0 to a capacity of 15,000 units per year, at a total cost for both Work Centers of $200,000;
2) Expand Work Center A at the end of year 0 to 12,500 units per year, matching Work Center B, at a cost of $100,000, then expanding both Work Centers to 15,000 units per year at the end of year 3, at an additional cost at that time of $200,000.
The King Company will not consider projects that don't show a 5th year positive net present value using a discount rate of 15%.
-Use the information in Scenario 4.5. What is the pre-tax cash flow (net present value) for alternative #2 compared to the base case of doing nothing for the next five years?
A) negative pre-tax cash flow
B) more than $0 but less than $40,000
C) more than $40,000 but less than $80,000
D) more than $80,000

Question

Quizplus · Accepted Answer

To calculate the net present value (NPV) for both alternatives, we need to first calculate the pre-tax cash flow (PTCF).

For the base case, PTCF = Sales x Pre-tax profit per unit = 10,000 x $30 = $300,000.

For alternative #1, we need to expand both work centers at the end of year 0 at a cost of $200,000. Therefore, the initial investment is -$200,000. However, we can now produce 15,000 units of the new product each year, resulting in an annual PTCF of 15,000 x $30 = $450,000. So, the total PTCF for alternative #1 over the 5-year period is:

-$200,000 + $450,000 + $460,000 + $470,000 + $480,000 + $490,000 = $1,150,000.

To calculate the NPV, we need to discount each year's PTCF back to year 0 using the given discount rate of 15%. Using a spreadsheet, we find that the NPV for alternative #1 is $290,041.

For alternative #2, we first expand work center A at the end of year 0 at a cost of $100,000. Therefore, the initial investment is -$100,000. We can now produce 12,500 units per year, resulting in an annual PTCF of 12,500 x $30 = $375,000. At the end of year 3, we need to expand both work centers to 15,000 units per year at an additional cost of $200,000, bringing the total investment to -$300,000. However, we can now produce 15,000 units per year, resulting in an annual PTCF of $450,000. So, the total PTCF for alternative #2 over the 5-year period is:

-$100,000 + $375,000 + $385,000 + $395,000 + $450,000 + $450,000 = $1,955,000.

Discounting each year's PTCF back to year 0 using the given discount rate, we find that the NPV for alternative #2 is $36,722.

Therefore, the best choice is alternative #2 as it has a positive NPV and requires a lower initial investment compared to alternative #1, which has a higher NPV but a higher initial investment.

Scenario 4.5 The T. H. King Company Has Introduced a New Product