Ben Guslists, vice-president of sales, has recommended adding a new product line. A market study and cost analysis show that the new line should yield the following annual results:
New Sales $2,800,000.00
Cost of Sales $1,600,000.00
Operating Expenses $200,000.00
Total Expenses $1,800,000.00
Income before Income taxes $1,000,000.00
Income taxes (40%) $400,000.00
Net Income $600,000.00
Depreciation of $150,000.00 is included in total expenses. Cost of sales and operating expenses include only direct costs of the new line.
Financial data for last year, considered to be a typical year, are:
Net Sales $12,000,000.00
Cost of Sales $7,500,000.00
Operating Expenses $1,800,000.00
Total Expenses $9,300,000.00
Operating Income $2,700,000.00
Interest Expense $100,000.00
Income before Income taxes $2,600,000.00
Income taxes (40%) $1,040,000.00
Net Income $1,560,000.00
Total Assets $12,000,000.00
Current Liabilities $3,000,000.00
Long term debt $1,000,000.00
Shareholders’ equity $8,000,000.00
Total liabilities and equities $12,000,000.00
Depreciation expense included totals $400,000.00 for the firm.
The investment in additional equipment for the production and sale of the new product line has been estimated at $3,000,000.00. “The new product line will yield a 20 percent return on assets,” Guslists states.
Steve Grunewald, the vice-president of production, interrupts, “Are you talking about a cash-flow return, Ben?” he asks. “No,” Guslists answers. “When depreciation is added back, the cash-flow return will be greater.”
The vice-president of finance, Jude Gallagher, asks, “How do you think we should finance the investment?”
“We should be able to issue long term notes”, Guslits responds. “Our debt at the present time is modest. And with debt financing, we gain the advantage of leverage.”
“In your estimate, Ben you forgot to include any interest cost. It will cost us $150,000.00 after income taxes to finance $3,000,000.00,” Gallagher replies.
Required:
1.What impacts will the new product line have on profit measures and cash flows?
2.Examine and comment on Guslits’ strategy to finance the investment. Is it likely that shareholders will be impressed with the investment? Why?
3.In your opinion, is the investment attractive? Explain.
ANSWERS (for checking)
1. Implementation of the new product line will yield a total product of $2,010,000 unlike profit last year with only $1,560,000.00. In addition, cash inflows after implementation will be $2,340,000.00 compared to last year with only $1,800,000.00
2. Guslits used debt financing to finance the new product line of the company, it means that he chose to issue long term payable incurring interest cost rather than issuing share of stocks or equity financing. It is noted that the company's debt to equity ratio last year was only 50% however with the new product line, the company's debt to equity will be increased to 87.5% making them highly leveraged and exposing them to a possible default in a worst case scenario. But in this scenario, the possible gain outweights the cost of paying the interest. Overall, the new investment is impressive because both the overall profit and cash inflows increased by $450,000 and $540,000 respectively.
3. Yes, the investment is attractive because it will have a positive impact when it comes to profit and cash flows however, the company will have a negative net cost of investment amounting to $810,000 but in the opinion, it is common since it is only in the first year of operation. In addition to this, the payback period is only 5.833 years; this means that it will only take 5 years and 10 months to recover their investment and the remaining 14 years and 2 months will produce net profit for the company (life of investment is 20 years)
Thank you!
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