Fluffy Cupcake Company (FCC) is considering expanding by buying a new machine to add to its existing bank of equipment used for the business. Cost of the machine is $42,000 with a 10-yr useful life with expectation of zero terminal disposal value.
This investment is expected to increase the cash revenues by $23,000 annually during the life of the asset and will have annual operating expense outlay of $18,000 per annum.
FCC cost of capital is 6% and the company has no existing debt and their corporate tax rate is 30%
Should the proposal be accepted by FCC?
One of FCC’s competitors Brownie Cake Company (BCC) is also interested in installing the same machine and projects the identical financial inflows of $23,000 per annum. However it has a different structure as follows:
Equity – 75 %
Debt – 25%
Cost of borrowing – 7.5%
Cost of capital – 5%
Corporate tax rate – 25%
Operating cost for the machine would be $15,000 per annum
Should the proposal be accepted by BCC?
It was discovered after further analysis that the cash flows during the project life would vary as follows:
Income will increase by 2% each year during the life of the project
Cost will increase by 1.25% each year
In year 6 a special maintenance adjustment will have to be carried out on the machine at a cost of $3,000; this will be written into the sale agreement with the manufacturers and the cost cannot be avoided by either FCC or BCC.
The machine will have a scrap value of 5% of cost after 10 years; the manufacturer has a recycling plant that buys old machines for immediate cash.
Should the proposal be accepted by FCC and BCC after these changes?
Sharp Shark Financing Ltd is offering a lease proposal to either company which requires payment of $4,620 each year for the 10 year investment period. Using the figures from the initial proposal ONLY evaluate the offer from Sharp Shark and calculate whether or not this is a viable option to either FCC or BCC.
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