Assignment
Your client Smooth Fabric, Inc. is a manufacturer of nylon fabric commonly used in the sports gear industry. The company's Northern Philadelphia factory will become idle on December 31, 2016, and decisions need to be made about the future of the factory. Morgan Bell, the corporate controller, has asked you to consider and analyze the following three options regarding the factory.
• The factory can be sold immediately for $600,000. The factory was originally purchased 10 years ago at a cost of $150,000. The useful life of the factory was 20 years for GAAP but the factory must be depreciated over 39 years for tax. Thus, accumulated depreciation under GAAP at the end of 2016 is $82,500. GAAP net book value at 12/31/16 equals $67,500. However, accumulated tax depreciation equals only $38,500; the tax net book value at 12/31/16 equals $111,500.
• The factory can be leased to the New Textile Corporation, one of Smooth Fabric's suppliers, for four years. Under the lease terms, New Textile would pay Smooth Fabric $130,000 rent per year (payable at year-end) and would grant Smooth Fabric a $13,000 annual discount off the normal price of fabric purchased by Smooth Fabric. (Assume that the discount is received at year-end for each of the four years.) New Textile would bear all of the plant's ownership costs. Smooth Fabric expects to sell this factory to New Textile for $450,000 at the end of the four-year lease.
• The factory could be used for four years to make souvenir jackets for the upcoming Olympics. Fixed overhead costs to be incurred before any equipment upgrades are estimated to be $10,000 annually for the four-year period. The jackets are expected to sell for $65 each. Variable cost per unit is expected to be $45 because royalty rates are high. The following production and sales of jackets are expected: 2017, 10,000 units; 2018, 12,000 units; 2019, 15,000 units; 2020, 6,000 units. In order to manufacture the jackets, some of the plant equipment would need to be upgraded at an immediate cost of $112,000 plus installation costs of $8,000. The equipment would be depreciated using the straight-line depreciation method and zero terminal disposal value over the four years it would be in use. Because of the equipment upgrades, Smooth Fabric could sell the factory for $550,000 at the end of four years. No change in working capital would be required.
Smooth Fabric treats all cash flows as if they occur at the end of the year, and it uses an after-tax required rate of return of 12%. Smooth Fabric is subject to a 35% tax rate on all income, including capital gains.
Calculate the net present value of each of the alternatives and determine which alternative Smooth Fabric should choose. Prepare a well formatted and clearly presented excel spreadsheet. It should be in the form that you could present to your client. List out any assumptions.
Based on your decision, prepare the required journal entry.