Custom Search

Working Capital Management

The efficiency gains resulting from a just-in-time inventory management system will allow a firm to reduce its level of inventories permanently by $250,000. What is the most the firm should be willing to pay for installing the system?

28. Project Evaluation. Better Mousetraps has developed a new trap. It can go into production for an initial investment in equipment of $6 million. The equipment will be depreciated straight line over 5 years to a value of zero, but in fact it can be sold after 5 years for $500,000. The firm believes that working capital at each date must be maintained at a level of 10 percent of next year`s forecast sales. The firm estimates production costs equal to $1.50 per trap and believes that the traps can be sold for $4 each. Sales forecasts are given in the following table. The project will come to an end in 5 years, when the trap becomes technologically obsolete. The firm`s tax bracket is 35 percent, and the required rate of return on the project is 12 percent. What is project NPV?

29. Working Capital Management. Return to the previous problem. Suppose the firm can cut its requirements for working capital in half by using better inventory control systems. By how much will this increase project NPV?

30. Project Evaluation. PC Shopping Network may upgrade its modem pool. It last upgraded 2 years ago, when it spent $115 million on equipment with an assumed life of 5 years and an assumed salvage value of $15 million for tax purposes. The firm uses straight-line depreciation. \

The old equipment can be sold today for $80 million. A new modem pool can be installed today for $150 million. This will have a 3-year life, and will be depreciated to zero using straight-line depreciation. The new equipment will enable the firm to increase sales by $25 million per year and decrease operating costs by $10 million per year. At the end of 3 years, the new equipment will be worthless. Assume the firm`s tax rate is 35 percent and the discount rate for projects of this sort is 12 percent.

2 a,b. The site and buildings could have been sold or put to another use. Their values are opportunity costs, which should be treated as incremental cash outflows.

c. Demolition costs are incremental cash outflows.

d. The cost of the access road is sunk and not incremental.

e. Lost cash flows from other projects are incremental cash outflows.

f. Depreciation is not a cash expense and should not be included, except as it affects taxes. (Taxes are discussed later in this material.)

3 Actual health costs will be increasing at about 7 percent a year.

Jack Tar, CFO of Sheetbend & Halyard, Inc., opened the company-confidential envelope. It contained a draft of a competitive bid for a contract to supply duffel canvas to the U.S. Navy. The cover memo from Sheetbend`s CEO asked Mr. Tar to review the bid before it was submitted. The bid and its supporting documents had been prepared by

Sheetbend`s sales staff. It called for Sheetbend to supply 100,000 yards of duffel canvas per year for 5 years. The proposed selling price was fixed at $30 per yard.

Mr. Tar was not usually involved in sales, but this bid was unusual in at least two respects. First, if accepted by the navy, it would commit Sheetbend to a fixed price, long-term contract. Second, producing the duffel canvas would require an investment of $1.5 million to purchase machinery and to refurbish Sheetbend`s plant in Pleasantboro, Maine. Mr. Tar set to work and by the end of the week had collected the following facts and assumptions:

The plant in Pleasantboro had been built in the early 1900s and is now idle. The plant was fully depreciated on Sheetbend`s books, except for the purchase cost of the land (in 1947) of $10,000.

Now that the land was valuable shorefront property, Mr. Tar thought the land and the idle plant could be sold, immediately or in the future, for $600,000.

Refurbishing the plant would cost $500,000. This investment would be depreciated for tax purposes on the 10-year MACRS schedule.

The new machinery would cost $1 million. This investment could be depreciated on the 5-year MACRS schedule.

The refurbished plant and new machinery would last for many years. However, the remaining market for duffel canvas was small, and it was not clear that additional orders could be obtained once the navy contract was finished. The machinery was custom built and could be used only for duffel canvas. Its second-hand value at the end of 5 years was probably zero.

Table 4.8 shows the sales staff `s forecasts of income from the navy contract. Mr. Tar reviewed this forecast and decided that its assumptions were reasonable, except that the forecast used book, not tax, depreciation.

But the forecast income statement contained no mention of working capital. Mr. Tar thought that working capital would average about 10 percent of sales. Armed with this information, Mr. Tar constructed a spreadsheet to calculate the NPV of the duffel canvas project, assuming that

Sheetbend`s bid would be accepted by the navy. He had just finished debugging the spreadsheet when another confidential envelope arrived from Sheetbend`s CEO. It contained a firm offer from a Maine real estate developer to purchase

Sheetbend`s Pleasantboro land and plant for $1.5 million in cash. Should Mr. Tar recommend submitting the bid to the navy at the proposed price of $30 per yard? The discount rate for this project is 12 percent.