Table 6.5
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:
-Use the information in Table 6.5.What is the pre-tax cash flow (net present value)for alternative #1 compared to the base case of doing nothing for the next five years?

Question

Quizplus · Accepted Answer

For alternative #1, the investment cost for adding capacity at Work Center A and B is $150,000. The incremental pre-tax cash flows for each year are as follows:

- Year 0: -$150,000 (initial investment)
- Year 1: $20,000 [(11,000 units - 10,000 units) x $30 per unit]
- Year 2: $40,000 [(12,000 units - 11,000 units) x $30 per unit]
- Year 3: $60,000 [(13,000 units - 12,000 units) x $30 per unit]
- Year 4: $80,000 [(14,000 units - 13,000 units) x $30 per unit]
- Year 5: $100,000 [(15,000 units - 14,000 units) x $30 per unit]

To calculate the net present value, we use a discount rate of 10% and the following formula:

NPV = -Initial investment + (CF1 / (1+r)^1) + (CF2 / (1+r)^2) + ... + (CFn / (1+r)^n)

Where:
- CF = cash flow for each year
- r = discount rate
- n = number of years

Using this formula, we get:

NPV = -$150,000 + ($20,000 / 1.1) + ($40,000 / 1.1^2) + ($60,000 / 1.1^3) + ($80,000 / 1.1^4) + ($100,000 / 1.1^5)
NPV = -$150,000 + $16,787 + $30,336 + $40,845 + $48,140 + $50,609
NPV = $36,717

Therefore, the pre-tax cash flow for alternative #1 is more than $40,000 but less than $80,000.

The best choice would be to pursue alternative #1, as it has a positive net present value and would result in increased profits for T.H.King Company over the next five years.

Table 6.5 The T.H.King Company Has Introduced a New Product Line That