AROMAX Ltd is considering a new line of office chairs and has employed a marketing consultant for $50,000 to report on the viability of the new product. The firm expects that this range of chairs will be sold on average at $52 per chair and they will be able to sell 25,000 chairs per year. Whilst unit sales are expected to remain at the same level for the project’s 10 year life, sales price over the life of the product is expected to increase at the long-term rate of inflation (estimated at 2.15%) per year. The cost of raw material will be $17.50 per chair, packaging costs are expected to be 7% of year 1 sales amount, and miscellaneous fixed costs are estimated to be $385,000 p.a. AROMAX expects all costs will increase by 0.25% more than the rate of inflation per year. If AROMAX proceeds with this project it would need to extend their manufacturing facility and production line at an estimated cost of $1,000,000 and the new equipment will cost another $1,000,000. The extended part of the facility and production line and the equipment will be depreciated on a straight-line basis to zero salvage value over the 10 year life of the project. It is estimated the various components of equipment can be sold for $300,000 at the completion of the project. The firm requires a 12% required rate of return and the tax rate is 30%. 1. Calculate the incremental cash flows for each year (Y0 – Y10). 2. Calculate the net present value. 3. Calculate the profitability index. 4. Calculate the discounted payback period. 5. Calculate the payback period.

EBK CONTEMPORARY FINANCIAL MANAGEMENT

14th Edition

ISBN:9781337514835

Author:MOYER

Publisher:MOYER

Chapter10: Capital Budgeting: Decision Criteria And Real Option

Section: Chapter Questions

Problem 14P

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AROMAX Ltd is considering a new line of office chairs and has employed a marketing consultant for $50,000 to report on the viability of the new product. The firm expects that this range of chairs will be sold on average at $52 per chair and they will be able to sell 25,000 chairs per year. Whilst unit sales are expected to remain at the same level for the project’s 10 year life, sales price over the life of the product is expected to increase at the long-term rate of inflation (estimated at 2.15%) per year. The cost of raw material will be $17.50 per chair, packaging costs are expected to be 7% of year 1 sales amount, and miscellaneous fixed costs are estimated to be $385,000 p.a. AROMAX expects all costs will increase by 0.25% more than the rate of inflation per year. If AROMAX proceeds with this project it would need to extend their manufacturing facility and production line at an estimated cost of $1,000,000 and the new equipment will cost another $1,000,000. The extended part of the facility and production line and the equipment will be depreciated on a straight-line basis to zero salvage value over the 10 year life of the project. It is estimated the various components of equipment can be sold for $300,000 at the completion of the project. The firm requires a 12% required rate of return and the tax rate is 30%. 1. Calculate the incremental cash flows for each year (Y0 – Y10). 2. Calculate the net present value. 3. Calculate the profitability index. 4. Calculate the discounted payback period. 5. Calculate the payback period.

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