I. An overall risk profile of the company based on current economic and industry issues that it may be
facing.
Sol :
Company’s operation is directly affected by the current economic and industry issues prevailing in the
economy. Company is comparatively more risky as compared to the prevailing market this is due to the
industry with which it belongs. However with the expansion in capacity and raising of debt to finance its
operation the company will improve its performance.
II. Current company cash flow
a. You need to complete a cash flow statement for the company using the direct method.
Sol :
Particulars Amount $
Cash Flow from Operating Activity
cash Received from debtors 126,000
cash paid to creditors (83,000)
Selling & Administration (25,000)
Income Tax Paid -
Cash Flow from Operating Activity 18,000
Cash Flow from Financing Activity
Dividends Paid (10,000)
Cash Flow from Financing Activity (10,000)
Cash Flow from Investing Activity
Equipment Purchased (10,000)
Cash Flow from Investing Activity (10,000)
Net Cash Flow (2,000)
Add: Opening Cash & Cash Equivalents 7,000
Closing Cash & Cash Equivalents 5,000
b. Once you’ve completed the cash flow statement, answer the following questions:
i. What does this statement of cash flow tell you about the sources and uses of the company?
Sol:
The company has generated a cash of $18,000 from its operating activity. However the company has
paid a dividend of $10,000 as a part of its financing activity and has also purchased an equipment of
$10,000 as a part of its financing activity. Since the company has generated an $18,000 from its
operating activity and has made an outflow of $20,000 the company has utilized its opening cash to the
extent of $2000
ii. Is there anything ABC Company can do to improve the cash flow?
Sol :
In order to improve the company’s cash flow the company can extend the due date to pay the creditors.
Also the company can reduce the dividend of the company.
iii. Can this project be financed with current cash flow from the company? Why or why not?
Sol:
Current cash flow of the company is not sufficient to finance the project of the company if the company
continues the same dividend policy as at present. However if the financing policies are changes the
company can finance the project as the operating cash flow of the company is positive.
iv. If the company needs additional financing beyond what ABC Company can provide internally (either
now or sometime throughout the life of the project), how would you suggest the company obtain the
additional financing, equity or corporate debt, and why?
Sol:
The company should go for debt financing as currently the company is an unlevered company and it can
take the benefits of leverage by borrowing the money. Moreover raising of fund through equity
financing is not fruitfull as it will deteriorate the EPS of the company.
III. Product cost:
ABC Company believes that it has an additional 5,000 machine hours available in the current facility
before it would need to expand. ABC Company uses machine hours to allocate the fixed factory
overhead, and units sold to allocate the fixed sales expenses. ABC Company expects that it will take
twice as long to produce the expansion product as it currently takes to produce its existing product.
a. What is the product cost for the expansion product?
Sol :
Computation of Product Cost
Particulars
Amount
s
Direct Materials 28000
Direct labor 20000
Variable Factory Overhead 5000
Variable Selling Expense 1000
Fixed Factory Overhead 22000
Fixed Selling expenses 11250
Total Product Cost 87250
b. By adding this new expansion product, it helps to absorb the fixed factory and sales expenses. How
much cheaper does this expansion make the existing product?
Sol :
Computation of Product Cost
Particulars
Existing Product
(Before Expansion)
Expansion
Product
Existing Product
(After Expansion)
Direct Materials 104,000 28,000 104,000
Direct labor 224,000 20,000 224,000
Variable Factory
Overhead 40,000 5,000 40,000
Variable Selling Expense 16,000 1,000 16,000
Fixed Factory Overhead 198,000 22,000 176,000
Fixed Selling expenses 191,250 11,250 180,000
Total Product Cost 773,250 87,250 740,000
Product will get cheaper by 773,250-740,000 = 33,250
c. Assuming ABC Company wants a 40% gross margin for the new product, what selling price should it
set for the expansion product?
Sol:
Computation of Product Cost
Particulars Amounts
Direct Materials 28,000
Direct labor 20,000
Variable Factory Overhead 5,000
Variable Selling Expense 1,000
Fixed Factory Overhead 22,000
Fixed Selling expenses 11,250
Total Product Cost 87,250
Add: Gross Margin 34,900
Sales Value 122,150
Units Sold 5,000
Unit Sale Price 24.43
d. Assuming the same sales mix of these two products, what are the contribution margins and break-
even points by product?
Sol:
Computation of Contribution p.u.
Particulars Existing Product
Expansion
Product
Direct Materials 1.30 5.60
Direct labor 2.80 4.00
Variable Factory Overhead 0.50 1.00
Variable Selling Expense 0.20 0.20
Variable Cost 4.80 10.80
Sale Price 12.00 24.43
Contribution p.u. 7.20 13.63
Contribution Margin 60% 55.79%
Unit Sold 80,000.00 5,000.00
Average Contribution p.u. = 7.2*80000/85000 + 13.63*5000/85000 = 7.58
Total Fixed Cost = 198,000+191,250 = 389,250
Break Even Point = 389250/7.58 = 51353 units
Break Even for existing product = 51353*80000/85000 = 48333
Break Even for Expansion product = 51353-48333 = 3020
IV. Potential investments to accelerate profit:
ABC company has the option to purchase additional equipment that will cost about $42,000, and this
new equipment will produce the following savings in factory overhead costs over the next five years:
Year 1, $15,000
Year 2, $13,000
Year 3, $10,000
Year 4, $10,000
Year 5, $6,000
ABC Company uses the net-present-value method to analyze investments and desires a minimum rate
of return of 12% on the equipment.
a. What is the net present value of the proposed investment ignore income taxes and depreciation?
Sol :
Year Cash Flow
DF @
12% PV
0 (42,000) 1
(42,000
)
1 15,000
0.89285
7 13,393
2 13,000
0.79719
4 10,364
3 10,000 0.71178 7,118
4 10,000
0.63551
8 6,355
5 6,000
0.56742
7 3,405
Net Present Value
(1,366)
b. Assuming a 5-year straight-line depreciation, how will this impact the factory’s fixed costs for each
of the 5 years (and the implied product costs)? What about cash flow?
Sol :
New Equipment Cost = $42,000
Number of years = 5 years
Annual depreciation = 42000/5 = $8400
The factory fixed cost will increase by $8400 in each of the five years. However, this will not affect the
cash flow of the firm as depreciation is a non cash item. But this will reduce the tax expense of the
company thereby reducing the tax expense of the company.
c. Considering the cash flow impact of the equipment as well as the time-value of money, would you
recommend that ABC Company purchases the equipment? Why or why not?
Sol:
Assuming the tax rate of 40%. The revised NPV will be as follows –
Year Cash Flow
Dep. Tax
shield
Cash
Flows
DF @
12% PV
0 (42,000) (42,000) 1 (42,000)
1 15,000 3,360 18,360 0.892857 16,393
2 13,000 3,360 16,360 0.797194 13,042
3 10,000 3,360 13,360 0.71178 9,509
4 10,000 3,360 13,360 0.635518 8,491
5 6,000 3,360 9,360 0.567427 5,311
Net Present Value
10,746
Since the net present value after taking into account the effect of depreciation is positive the project
should be accepted. However if the depreciation is ignored the project should be rejected.
