Question

Duddy Kravitz owns the Saint Viateur Bagel store. His world famous bagels are hand rolled, boiled in honey-water and baked in a wood-burning oven. The store sells 5,000 bagels per day and is open 365 days of the year. The bagels are so popular that, on weekends, the customer line-up runs half-way down the block. Uncle Benjy thinks that the wood-fired oven should be replaced by a modern gas oven, which would reduce costs by $0.02 per bagel. A new oven would cost $105,000.Duddy is considering Uncle Benjy's idea, but he only plans to be in business for another two years. The bagels are sold for $0.75 each. The cost of producing each bagel with the wood-burning oven is $0.50 which includes labor and raw materials. The current oven was purchased thirty years ago for $20,000. It could be sold today for $5,000 and will be worth $3,000 in two years. A new oven costs $105,000 today and could be sold for $55,000 in two years. Duddy's cost of capital is 9%. Assume that investment cash flows occur immediately, and that sales and production costs occur at the end of the year. Assume that both ovens are classified as 10-year property and depreciated using the MACRS system. The tax rate is 35%.What are the terminal year cash flows?a. 30,340b. $36,500c. $62,260d. $90,600e. $94,500

Answer 1

Answer:

No option is even close. With yearly revenues of $1,368,750 and a contribution margin ratio of 36% and 33.33%, the cash flows are in the hundreds of thousands of $.

Explanation:

new oven:

contribution margin per bagel = $0.75 - $0.48 = $0.27

units sold per year = 5,000 x 365 = 1,825,000 x $0.27 = $492,750

initial outlay = $105,000 - [$5,000 x (1 - 35%)] = $103,250

depreciation year 1 = 10% x $105,000 = $10,500

depreciation year 2 = 18% x $105,000 = $18,900

after tax salvage value = $55,000 - [($55,000 - $75,600) x 35%] = $62,210

cash flow year 1 = [($492,750 - $10,500) x (1 - 35%)] + $10,500 = $323,962.50

cash flow year 2 (terminal cash flow) = [($492,750 - $18,900) x (1 - 35%)] + $18,900 + $62,210 = $389,112.50

old oven:

contribution margin per bagel = $0.75 - $0.50 = $0.25

units sold per year = 5,000 x 365 = 1,825,000 x $0.25 = $456,250

initial outlay = $0, and since the oven has been completely depreciated already, the depreciation expense is $0.

after tax salvage value = $3,000 x (1 - 35%) = $1,950

cash flow year 1 = $456,250 x (1 - 35%) = $296,562.50

cash flow year 2 (terminal cash flow) = [$456,250 x (1 - 35%)] + $1,950 = $298,512.50