Landover Construction Company’s most recent revenue was $4,124,000 with operating costs (exclusive of depreciation) of $1,176,300, depreciation expense
of $245,000, and interest expense of $30,000. Landover’s tax rate is 35%. Both revenues and costs for next year are expected to rise each year by 5 percent
with depreciation and interest expense to remain approximately the same. The Company’s president has asked you to evaluate the proposed acquisition of a
new earth mover. The mover’s base price is $50,493.92 and it would cost another $10,000 to modify it for special use. If acquired, the earth mover would be
deprecated using the straight-line method over its economic life of 3 years and then be sold for $15,000. An initial increase in spare parts inventory of
$2,190.15 would also be required. The earth mover would have no effect on revenues, but it is expected to save Landover $20,000 per year in operating costs,
mainly labor. Landover’s cost of capital is 7.13 percent.
If Landover decides to proceed with the acquisition, answer the following:
1. What is the proper cash flow amount to use as the initial investment? Show your computations.
2. What are the proper cash flow amounts that will occur over each of the 3 years of production? Show your computations.
3. Should the earth mover be purchased? Show your computations / justification
Sample Solution
1. The initial cash flow amount to be used as the initial investment is $73,683.97. This amount consists of the base price ($50,493.92) + cost to modify it for special use ($10,000) + increase in spare parts inventory ($2,190.15).
2. The proper cash flows that will occur over each of the 3 years of production are as follows:
Year 1 – Cash Inflow (Savings from operating costs due to acquisition): $20,000; Cash Outflow (Depreciation Expense): $16,815.33; Net Cash Flow: $3184.67
Sample Solution
1. The initial cash flow amount to be used as the initial investment is $73,683.97. This amount consists of the base price ($50,493.92) + cost to modify it for special use ($10,000) + increase in spare parts inventory ($2,190.15).
2. The proper cash flows that will occur over each of the 3 years of production are as follows:
Year 1 – Cash Inflow (Savings from operating costs due to acquisition): $20,000; Cash Outflow (Depreciation Expense): $16,815.33; Net Cash Flow: $3184.67
