Reference no: EM131543606

You are considering the purchase of a new zippy fabricating machine for your firm, Cherry Enterprises, Inc. CEI makes novelty items for wholesale to retail outlets located in tourist traps. The purchase of the zippy will allow CEI to market a new product, a walking stick with built-in bear repellant. In order to analyze the decisions to manufacture and sell the walking sticks and to lease the zippy, you have collected the following data, some of which may be relevant (all dollars in 2017 prices):

Cost of zippy = $5,000,000

Useful (and depreciable) life of zippy = 10 years

Salvage value (market and depreciation) of zippy = $0

Expected walking stick sales volume (in lots of 1000) = 2000/year

Wholesale price per 1000 lot of walking sticks = $899

Annual zippy maintenance contract costs = $110,000 (the only fixed cash cost)

Average variable cost per lot of walking sticks = $500

Additional working capital (supplies) required at beginning of year 1 only = $300,000

Current equity = $60,000,000

Current debt = $40,000,000

Marginal tax rate for CEI = 30%

Inflation rate = .03

Zippy can be financed in several ways. The following data pertain to financing options:

Required return on equity (real) = .05

Bank loan interest rate available, given current capital structure = .055

Lease contract with payments made in 10 equal annual installments, beginning at start of lease period. Lease contract includes maintenance costs.

Payment = $700,000

Evaluate the zippy as a business opportunity for CEI. Evaluate the lease financing option for the zippy as well. Although CEI is a tax-paying entity and could benefit from the use of MACRS depreciation, please use straight-line depreciation expense recognition.