Question

5. The Mallard Corporation is considering investing in a new cane manufacturing machine that has an estimated life of three years. The cost of the machine is $30,000 and the machine will be depreciated straight line over its three-year life to a residual value of $0. The machine will result in increased sales of 2000 canes in year 1. Sales are estimated to grow by 10% per year each year through year three. The price per cane that the corporation will charge its customers is $18 each and is to remain constant. The canes have a cost per unit to sort and pack of $9 each. Installation of the machine and the resulting increase in manufacturing capacity will require an increase in various net working capital accounts. It is estimated that the corporation needs to hold 2% of its annual sales in cash, 4% of its annual sales in accounts receivable, 9% of its annual sales in inventory, and 6% of its annual sales in accounts payable. The firm is in the 35% tax bracket and has a cost of capital of 10%. Required: a) What are the incremental EBIT and Unlevered Net Income in the third year for the corporation?

b) What is a sunk cost? What is an opportunity cost? What is an interest rate cost? Should these costs be included in the incremental cash flows for a project? Why or why not?

Answer 1

Solution:-

Sunk Cost- Sunk cost is also known as Irrelevant cost. Sunk cost is a cost which does not affect the decision making. A sunk cost is a money which already have spent and which cannot be recovered. For Example- A Manufacturing company may have a number of sunk cost i.e. Cost of Plant, property, equipment, Machinery, Factory Rent Expense etc. are known as Sunk Cost.

Interest Rate Cost- Interest Cost is amount of interest which borrowers paid over the life of the debt. It is only one factor in a loan analysis and also other things to be considered include opportunity cost, tax banefits.

Opportunity Cost- Opportunity cost is the cost which are loss of other Best alternative when one alternative in choosen. Formula-

Opportunity Cost = Return on Best Forgone Option - Return on choosen option.

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