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Cost of goods sold

$1,260,000

Wages and salaries

200,000

Rent

120,000

Depreciation

60,000

Utilities

40,000

Miscellaneous

30,000

Total

1,710,000

Net profit before tax

$ 90,000

Cunningham's sales and expenses have remained relatively constant over the past few years and are expected to continue unchanged in the near future. To increase sales, Cunningham is considering using some floor space for a small soda fountain. Cunningham would operate the soda fountain for an initial 3-year period and then would reevaluate its profitability. The soda fountain would require an incremental investment of $20,000 to lease furniture, equipment, utensils, and so on. This is the only capital investment required during the 3-year period. At the end of that time, additional capital would be required to continue operating the soda fountain, and no capital would be recovered if it were shut down. The soda fountain is expected to have annual sales of $100,000 and food and materials expenses of $20,000 per year. The soda fountain is also expected to increase wage and salary expenses by 8% and utility expenses by 5%. Because the soda fountain will reduce the floor space available for display of other merchandise, sales of non-soda fountain items are expected to decline by 10%.

A. Calculate net incremental cash flows for the soda fountain.

B. Assume that Cunningham has the capital necessary to install the soda fountain and that he places a 12% opportunity cost on those funds. Should the soda fountain be installed? Why or why not?

P15.9 Cash Flow Analysis. The Nigelwick Press, Inc. (NPI), is analyzing the potential profitability of three printing jobs put up for bid by the State Department of Revenue:

Job A Job B Job C

Projected winning bid (per unit)

$5.00

$8.00

$7.50

Direct cost per unit

$2.00

$4.30

$3.00

Annual unit sales volume

800,000

650,000

450,000

Annual distribution costs

$90,000

$75,000

$55,000

Investment required to produce annual volume

$5,000,000

$5,200,000

$4,000,000

Assume that (1) the company's marginal city-plus-state-plus-federal tax rate is 50%; (2) each job is expected to have a 6-year life; (3) the firm uses straight-line depreciation; (4) the average cost of capital is 14%; (5) the jobs have the same risk as the firm's other business; and (6) the company has already spent $60,000 on developing the preceding data. This $60,000 has been capitalized and will be amortized over the life of the project.

A. What is the expected net cash flow each year? (Hint: Cash flow equals net profit after taxes plus depreciation and amortization charges.)

B. What is the net present value of each project? On which project, if any, should NPI bid?

C. Suppose that NPI's primary business is quite cyclical, improving and declining with the economy, but that job A is expected to be countercyclical. Might this have any bearing on your decision?

P15.10 Cost of Capital. Eureka Membership Warehouse, Inc., is a rapidly growing chain of retail outlets offering brand-name merchandise at discount prices. A security analyst's report issued by a national brokerage firm indicates that debt yielding 13% composes 25% of Eureka's overall capital structure. Furthermore, both earnings and dividends are expected to grow at a rate of 15% per year.

Currently, common stock in the company is priced at $30, and it should pay $1.50 per share in dividends during the coming year. This yield compares favorably with the 8% return currently available on risk-free securities and the 14% average for all common stocks, given the company's estimated beta of 2.

A. Calculate Eureka's component cost of equity using both the capital asset pricing model and the dividend yield plus expected growth model.

B. Assuming a 40% marginal federal-plus-state income tax rate, calculate Eureka's weighted-average cost of capital.

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