Reference no: EM133102813

Question - Big L's Clothing is considering branching out into the jogging shorts market. A machine costing $12,000 must be purchased to manufacture the shorts. It would last for three years and have no salvage value at the end of the three years. The shorts line would also be dropped (or re-evaluated) at the end of three years.

After some careful market research, and discussions with the production team, Big L's Clothing expects the following production and sales over the three years:

	Year 1	Year 2	Year 3
Production (in units)	8,000	5,000	7,000
Sales (in units)	5,000	6,000	9,000
Variable Prod. Costs (per unit)	$3.00	$3.00	$3.00
Variable Selling Costs (per unit)	$1.00	$1.00	$1.00
Selling Price (per unit)	$5.00	$5.00	$5.00

The Variable production cost per unit includes the incremental labor and materials required to produce a pair of jogging shorts. The selling price per unit was determined after careful consideration of market-clearing demand. The variable selling cost includes the commissions paid to the sales force for each pair of shorts sold to the market. Other than the costs described above, investing in the jogging shorts does not include additional administrative or other production costs.

Big L's clothing uses straight-line depreciation (remember to depreciate the machine in your analysis). Fixed overhead costs are allocated based on units of production using actual production and are included in the Cost of Goods Sold. Big L's clothing uses a first-in-first-out (FIFO) inventory system. The tax rate is 40%, and the company uses a discount rate of 12% to evaluate projects.

Assume that all sales are paid in the case at the end of the year and all expenses (including taxes) are paid in cash at the end of the year in which they occur. However, Big L's Clothing must pay for the machine in money on the day it is delivered and cannot begin production (and cannot make any sales) until the machine has been purchased (this means that you buy and pay for the machine just before the start of Year 1, let's call this "Year 0").

Required -

1. What is the total cost of goods sold in year 1?

2. What is the pre-tax net income in the second year if you were to undertake the jogging short division?

3. What is the net cash flow in the third year if you were to undertake the jogging shorts division (Year 0 is, of course, -$12,000)?

4. What is the net present value of the jogging shorts division?

5. What is the total income gained (i.e., the sum, undiscounted) if you were to undertake the jogging short division?

6. What is the total net cash flow earned (i.e., the sum including Year 0, undiscounted) if you were to undertake the jogging short division?

7. If you were the CEO of Big L's Clothing and compensated only as a net income function, would you take the project? Explain why in 1-2 sentences. Assume that this is the only reasonable incremental investment opportunity available to Big L's clothing, and the other divisions are operating at market-clearing demand volumes.

8. Other than selling more shorts at a higher price or reducing costs of production or SG&A, do you have any recommendations that would increase the contribution of the short jogging division to the success of Big L's Clothing financially?