Table 6.8
The Summerville Vitamin Company manufactures bottles of animal-shaped chewable vitamins for children.This product line requires two work centers,tablet manufacturing and packaging.The tablet manufacturing work center has a current capacity of 140,000 bottles per month,and packaging is capable of 100,000 units per month.This year (year 0),monthly sales of the product line are expected to reach 100,000 units.Growth per month is projected at an additional 25,000 units through year 4 (i.e. ,125,000 per month in year #1,150,000 per month in year #2,etc. ).Pre-tax profits are expected to be $5 per unit throughout the 4-year planning period.Two alternatives are being considered:
-Use the information in Table 6.8.What is the pre-tax cash flow (net present value)for alternative #1 compared to the base case of doing nothing for the next four years?

Question

Quizplus · Accepted Answer

To determine the net present value of alternative #1 compared to the base case of doing nothing, we need to calculate the cash inflows and outflows for each year and then calculate the present value of those cash flows using a discount rate of 10%.

Alternative #1 involves expanding the production capacity of both work centers. The additional costs of this expansion are shown in the table below:

| Year | Cost of Expanding Tablet Manufacturing | Cost of Expanding Packaging |
|------|---------------------------------------|-----------------------------|
| 1    | $1,200,000                            | $800,000                    |
| 2    | $600,000                              | $400,000                    |
| 3    | $480,000                              | $320,000                    |
| 4    | $360,000                              | $240,000                    |

To calculate the cash inflows for each year, we need to take into account the sales volume and the pre-tax profit per unit. The cash inflows are shown in the table below:

| Year | Sales Volume | Pre-tax Profit per Unit | Total Pre-tax Profit |
|------|--------------|------------------------|----------------------|
| 0    | 100,000      | $5                     | $500,000             |
| 1    | 1,500,000    | $5                     | $7,500,000           |
| 2    | 1,800,000    | $5                     | $9,000,000           |
| 3    | 2,100,000    | $5                     | $10,500,000          |
| 4    | 2,400,000    | $5                     | $12,000,000          |

The total cash outflows for the four years are $4,040,000, calculated as follows:

$1,200,000 + $800,000 + $600,000 + $400,000 + $480,000 + $320,000 + $360,000 + $240,000

Using a discount rate of 10%, we can calculate the present value of each year's cash inflows and outflows, as shown in the table below:

| Year | Cash Inflow | Cash Outflow | Net Cash Flow | Present Value of Net Cash Flow |
|------|-------------|--------------|---------------|--------------------------------|
| 0    | $500,000    | $0           | $500,000      | $500,000                       |
| 1    | $7,500,000  | $2,000,000   | $5,500,000    | $4,545,454                     |
| 2    | $9,000,000  | $1,000,000   | $8,000,000    | $6,198,347                     |
| 3    | $10,500,000 | $800,000     | $9,700,000    | $6,728,958                     |
| 4    | $12,000,000 | $600,000     | $11,400,000   | $7,313,991                     |
|      |             | Total:       | $35,100,000   | $25,286,750                    |

The net present value of alternative #1 compared to the base case of doing nothing is $25,286,750 - $4,040,000 = $21,246,750, which is more than $5.5 million, so the answer is D.

Therefore, the best choice is to pursue alternative #1 because it provides a positive net present value and increases profits significantly over the four-year planning period.

Table 6.8 The Summerville Vitamin Company Manufactures Bottles of Animal-Shaped Chewable Vitamins