A customer has approached CapiCal industries with a purchase order for a specialty product it needs for the next three years. CapiCal no longer produces the product and the related fully depreciated manufacturing equipment was going to be sold for $50,000. It will take $35,000 to recondition it and approximately 155 hours employee time at $18.50 an hour to set the equipment up. Both set up and production can be incorporated in the current space and in the factory schedule without having to hire additional labour. Sales Revenue for the special order is expected to be $120,000 per year. Direct material for the special order will amount to 55% of revenue. Working capital will expand by $16,000 immediately. Allocated administration costs amount to $5,000. Interest expense is $1,400. The company uses straight-line amortization and a hurdle rate of 10%. What is the net present value (NPV) of the order?

Question

Quizplus · Accepted Answer

The correct answer is A. The NPV of the order is $33,290. The calculation is as follows:Year 0:- Sales revenue: $120,000- Direct material: $66,000 (55% of revenue)- Reconditioning cost: $35,000- Setup cost: $2,833 (155 hours x $18.50)- Working capital expansion: $16,000- Allocated administration costs: $5,000- Interest expense: $1,400- Net income: $1,767Year 1:- Sales revenue: $120,000- Direct material: $66,000- Allocated administration costs: $5,000- Interest expense: $1,400- Net income: $47,600Year 2:- Sales revenue: $120,000- Direct material: $66,000- Allocated administration costs: $5,000- Interest expense: $1,400- Net income: $47,600Year 3:- Sales revenue: $120,000- Direct material: $66,000- Allocated administration costs: $5,000- Interest expense: $1,400- Net income: $47,600NPV = -$50,000 + $1,767/(1+0.10)^0 + $47,600/(1+0.10)^1 + $47,600/(1+0.10)^2 + $47,600/(1+0.10)^3= $33,290

A Customer Has Approached CapiCal Industries with a Purchase Order