Question

Tomas Co. wants to add a production line. To do this, the company must spend $200,000 to expand its current building and purchase $1 million in new equipment. The new production line is expected to produce 100,000 units per year of a new product, which has a projected sales price of $7.75 per unit and a variable cost of $3.90 per unit. Introducing the new product is expected to cause sales of existing products to decrease by $89,000 per year and existing costs to decline by $49,000 per year. Fixed costs of the new line will be $142,000 annually. The company expects net working capital to increase by $1,800,000 when the new line is added, and then decrease by that amount when the project ends in five years. Tomas also expects to sell the equipment and building space at the end of the project in five years to net $320,990.36 after taxes. The company has a 34 percent marginal tax rate. Tomas’ cost of capital is 11%.

Answer 1

Tomas Co. is contemplating an expansion to introduce a new product line, requiring an analysis of costs, sales, and the effects on net working capital and existing product sales. An initial investment, ongoing operational costs, and the project's end value must be considered alongside the company's cost of capital to evaluate the project's financial viability.

Step-by-step explanation:

Evaluating the Addition of a New Production Line

Tomas Co. is considering the addition of a new production line which involves capital expenditures and has ramifications on the company's income statement and balance sheet. The initial investment consists of $200,000 for building expansion and $1 million for new equipment. This production line would produce a new product with expected sales of 100,000 units annually at $7.75 per unit and variable costs of $3.90 per unit. However, it is anticipated that this new product line will lead to a decrease in sales of existing products by $89,000, although it will also result in existing costs declining by $49,000 per year. Moreover, fixed costs associated with the new line are anticipated to be $142,000 annually. Furthermore, there will be an increase in net working capital by $1,800,000, which will subsequently decrease by the same amount at the end of the five-year project period. At the project's conclusion, Tomas Co. expects to sell the equipment and real estate for a net of $320,990.36 after taxes. The company operates with a 34 percent marginal tax rate and uses an 11 percent cost of capital for investment evaluation.

Analysis of Project Viability

To assess the feasibility of the new production line, Tomas Co. will need to conduct a thorough financial analysis. This will include calculating the project's net present value (NPV), internal rate of return (IRR), and payback period, with consideration given to the economies of scale and understanding how the fixed and variable costs will affect profitability. Incorporating changes in net working capital and the terminal value of the assets sold at the end of the project are also integral to an accurate evaluation.