Question 1:
Sunk costs and opportunity costs. Masters Golf Products, Inc., spent 3 years and $1,000,000 to develop its new line of club heads to replace a line that is becoming obsolete. In order to begin manufacturing the new line, the company will have to invest $1,800,000 in new equipment. The new clubs are expect to generate an increase in operating cash inflows of $750,000 per year for the next 10 years. The company has determined that the existing line could be sold to a competitor for $250,000. In addition, rather than developing the new golf club line itself, Masters could sell the rights to the line for $400,000.
a. How should the $1,000,000 in development costs be classified?
b. How should the $250,000 sale price for the existing line be classified?
c. How should the $400,000 selling price for the rights to the new line be treated?
d. Depict all of the known relevant cash flows on a time line.
Question 2:
Integrative-Determining NPV. Lombard Company is contemplating the purchase of a new high-speed widget grinder to replace the existing grinder. The existing grinder was purchased 2 years ago at an installed cost of $60. The existing grinder could be used for 5 more years. The new grinder costs $105,000 and requires $5,000 in installation costs; it has a 5 year life. The existing grinder can currently be sold for $70,000 but removal and cleanup costs will total $42,000.
To support the increased business resulting from purchase of the new grinder, accounts receivable would increase by $40,000, inventories by $30,000 and accounts payable by $58,000. At the end of 5 years, the existing grinder is expected to have a market value of zero; the new grinder would be to net $29,000 after removal and clean up costs. Grinders are considered a Class 8 asset with a CCA rate of 20 percent. Lombard's tax rate is 40 percent and cost of capital is 12 percent. The estimated operating income over the 5 years for both the new and existing grinder are shown in the table.
|
Year
|
New grinder (operating income before taxes)
|
Existing grinder (operating income before taxes)
|
|
1
|
$43,000
|
$26,000
|
|
2
|
43,000
|
24,000
|
|
3
|
43,000
|
22,000
|
|
4
|
43,000
|
20,000
|
|
5
|
43,000
|
18,000
|
Should Lombard replace the existing grinder? Explain.