WM3 is a company who is looking to expand. There is a potential deal with a furniture company but MW3 is not sure if they should take this deal.
The furniture company is offering a 4 year contract for 100,000 units per year at a fixed price of $55.50 per unit. WM3 has sufficient manufacturing and warehouse space to support this project. Wally's people have estimated that the unit cost to produce this item will be $28.50 for materials, $12.50 for labor and $8.50 in variable overhead (60% wages and 40% other items) at todays costs. No additional fixed costs are anticipated although the accounting manager wants to charge the new product a share of the fixed costs based on the square footage this product will need. This amounts to $200,000 per year.
Production will require the purchase of 2 new stamping presses at $125,000 each. Presses has a long life and decline in value at 10%/year. 3 Dies will also be required at $36,000 each. Each die, is expected to ave a useful life of 400,000 units, but they have no value except for the product. WM3 production planning people are planning on keeping an average of a one-months supply of raw material inventory on hand. WM3 expects to be able to start production next year.
WM3 has been assured by the furniture company that they will pay all invoices within 72 hours as long as he meets delivery schedules. The furniture company will expect weekly deliveries equal to 1/50th of the annual demand. To insure timely deliveries WM3 plans to keep a week's supply of finished-goods inventory on hand.
WM3 has $100,000 on hand to invest in this project. His banker has told him that if he invests $100,000 on hand in this project, the bank will finance the presses at 8% per year with yearly payments over 4 years with 10% down. THe dies can be financed at 8% over 3 years with 30% down. Inventory can be financed against the company's revolving credit limit at a rate of 10%- paying just the interest each year and using the inventory as collateral until the projects end when the bank is repaid the loan's principal by liquidating the inventory. A "last in-first out" method is used to value inventory.
WM3's real after-tax MARR is 12%. WM3 is expecting 3% per year growth in raw materials prices, 2% growth per year in wages. He expects the general inflation rate to be 2.5%.
With actual taxable income steady at $525,000 per year WM3 is concerned that his business is losing ground and this new furniture deal might be a new opening. WM3 pays state income taxes at a rate of 11%.
Should WM3 proceed in this project?
Option: Does financing this project make it more or less attractive (assuming there were funds in the company available to use for this project)?
To determine whether WM3 should proceed with the project and whether financing makes it more or less attractive, we need to analyze the financial aspects of the deal.
1. Calculate the revenue:
The furniture company is offering a 4-year contract for 100,000 units per year at a fixed price of $55.50 per unit. Revenue per year can be calculated as $55.50 per unit * 100,000 units = $5,550,000.
2. Calculate the cost of production:
The unit cost to produce the item is $28.50 for materials, $12.50 for labor, and $8.50 in variable overhead (60% wages and 40% other items) at today's costs. The total variable cost per unit is $28.50 + $12.50 + $8.50 = $49.50. The total fixed cost per unit is $200,000 / 100,000 units = $2.00.
3. Calculate the investment required:
WM3 needs to purchase 2 new stamping presses at $125,000 each, totaling $250,000. The presses decline in value at 10% per year. The dies cost $36,000 each, totaling $108,000. The dies have a useful life of 400,000 units.
4. Calculate the financing options:
WM3 has $100,000 on hand to invest. The bank will finance the presses at 8% per year with yearly payments over 4 years and 10% down. The dies can be financed at 8% over 3 years with 30% down. Inventory can be financed against the company's revolving credit limit at a rate of 10%, paying only the interest each year.
5. Consider taxes and inflation:
WM3's taxable income is $525,000 per year, and the state income tax rate is 11%. There is an expected growth rate of 3% per year in raw material prices, 2% growth per year in wages, and a general inflation rate of 2.5%.
6. Calculate the net present value (NPV) and determine profitability:
The NPV will assess the profitability of the project by considering the cash flows and the desired rate of return (MARR), which is 12%. The NPV should be positive for the project to be profitable.
After considering all these factors, we can determine whether WM3 should proceed with the project and whether financing makes it more or less attractive.