Ben Guslists, vice-president of sales, has recommended adding a new product line. A market study and cost analysis show that the new line should yield the following annual results:
New Sales $2,800,000.00
Cost of Sales $1,600,000.00
Operating Expenses $200,000.00
Total Expenses $1,800,000.00
Income before Income taxes $1,000,000.00
Income taxes (40%) $400,000.00
Net Income $600,000.00
Depreciation of $150,000.00 is included in total expenses. Cost of sales and operating expenses include only direct costs of the new line.
Financial data for last year, considered to be a typical year, are:
Net Sales $12,000,000.00
Cost of Sales $7,500,000.00
Operating Expenses $1,800,000.00
Total Expenses $9,300,000.00
Operating Income $2,700,000.00
Interest Expense $100,000.00
Income before Income taxes $2,600,000.00
Income taxes (40%) $1,040,000.00
Net Income $1,560,000.00
Total Assets $12,000,000.00
Current Liabilities $3,000,000.00
Long term debt $1,000,000.00
Shareholders’ equity $8,000,000.00
Total liabilities and equities $12,000,000.00
Depreciation expense included totals $400,000.00 for the firm.
The investment in additional equipment for the production and sale of the new product line has been estimated at $3,000,000.00. “The new product line will yield a 20 percent return on assets,” Guslists states.
Steve Grunewald, the vice-president of production, interrupts, “Are you talking about a cash-flow return, Ben?” he asks. “No,” Guslists answers. “When depreciation is added back, the cash-flow return will be greater.”
The vice-president of finance, Jude Gallagher, asks, “How do you think we should finance the investment?”
“We should be able to issue long term notes”, Guslits responds. “Our debt at the present time is modest. And with debt financing, we gain the advantage of leverage.”
“In your estimate, Ben you forgot to include any interest cost. It will cost us $150,000.00 after income taxes to finance $3,000,000.00,” Gallagher replies.
- What impacts will the new product line have on profit measures and cash flows?
- Examine and comment on Guslits’ strategy to finance the investment. Is it likely that shareholders will be impressed with the investment? Why?
- In your opinion, is the investment attractive? Explain.