Accounting for Decision Making and Control 7th Edition by Jerold Zimmerman

Exercise 6

Scottie Corporation
a. Scottie Corporation has been offered a contract to produce 100 castings a year for five years at a price of $200 per casting. Producing the castings will require an investment in the plant of $35,000 and operating costs of $50 per casting produced. For tax purposes, depreciation will be on a straight-line basis over five years, with a full year's depreciation taken in both the beginning and ending years. The tax rate is 40 percent and the market's required rate of return on investments of this type is 10 percent. Assume cash flows except the initial investment occur at the end of the relevant years. Should Scottie accept the contract?
b. Suppose that the contract in (a) involves the use of some warehouse space that Scottie can neither use in the business nor rent out. Just before Scottie accepts or rejects the contract, Kampmeier Realty offers to rent the space for $3,000 a year for five years if Scottie renovates the space. The renovations would cost $10,000. The renovations also would be depreciated on a straight-line basis over five years, and the required return on the rental project is also 10 percent.
(i) Does the rental offer change the net present value of the casting contract? Show all calculations.
(ii) Is the annual rent for the space an opportunity cost of the casting order? Why or why not?
Source: R. Watts.