Based on the income and the statements of cash flows from 2011 through 2015, did Mr. Martin
have positive net income an cash flow? Please show all work.
Background
MartinCo is a small company that has been in the Martin family for several generations. In 2010,
Mr. Martin added a new business line selling an exclusive and unique image processing sensor
that he had developed. For the last years, the business unit had done quite well, exceeding Mr.
Martin’ and the Board of Director’s expectations. Given that MartinCo had never worked in the
image processing industry, the project had originally been viewed as extremely risky with
several of the board members recommending against it. Even so, the project had prevailed and
the business unit had done well.
Recently, Mr. Martin had received inquiries from a major Photography and Imaging firm
(Canikon, Inc.) to exclusively use his image processing sensor or to purchase the rights to the
sensor outright with the intent of getting a larger manufacturer to produce the product. Mr.
Martin is faced with a dilemma. Should he choose to keep the rights to his product, he will have
to ramp up production to meet the demands of Canikon. Alternatively, should Mr. Martin
chooses not to expand his image processing business unit to meet Canikon's propositions,
Canikon could independently develop a similar sensor and cut him out of the market altogether.
Mr. Martin is loath to give up the rights to his designs and brand and realizes that he might have
to do so if the numbers don’t fall out well for his product.
Mr. Martin wants to compile a report for the business unit that will give him some insight into its
present operation and potentially a better understanding of whether an expansion would be a
feasible undertaking.
A big concern that Mr. Martin has is that Canikon intends to, and would be able to significantly
underprice his present product and cost structure. Canikon is currently a leading distributor in the
Photography and Imaging industry. Hence, the company has the ability to source a larger
manufacturer to produce a similar type of sensor and would able to bring economies of scale to
bear that Mr. Martin would have difficulty achieving.
------------------------------------------
Product Development and Initial investments
Mr. Martin invested significant time and expense in the development of his unique Image
Processing Sensor. He went through extensive development, testing, consumer feedback,
promotional giveaways and effort before proposing the product and business line to the board
members. All in all he had produced one hundred and fifty units before even having a fully
functional production line. Mr. Martin presented his ideas to the board at the 2nd quarter Board
of Directors meeting of 2010. Although there was some hesitation, the Board of Directors

approved the project and expected the purchase of equipment to be finalized with plans to have
the sensors to run off the lines and delivered to the distributors starting on January 1st, 2011.
Mr. Martin understood the risk that he was taking. The market was not well known to him, but
he felt that he had a good product that he could sell at a premium for the first years. He was
worried about his costs, but felt that he could bring those down if his sales were high enough. He
knew that he could not run the business unit if he could not reduce the $670 production cost to
produce the first unit. Particularly Mr. Martin aims to get the price to $600 or below within five
years. Had he known that he would be approached by Canikon when he started out and that he
would possibly be forced to get the price below $400, he might have given up there and then and
moved on to some other venture!
MartinCo invested $120,000 in equipment that was installed on site. The machinery has been
depreciated according to a MACRS 7 year schedule. A vehicle was also purchased for $25,000
and was to be depreciated according to a 3-year MACRS schedule.
------------------------------------------
Sales
Since the start of the Image Processing business unit, MartinCo has seen steady growth in the
sales of its sensors. Besides the 150 units that had been produced and given away before 2011 for
market testing purposes, MartinCo had increased its sales from 500 units in the first year to 1200
units by the fifth year.
Year
2011
2012
2013
2014
2015
Unit Sales
550
760
910
1150
1200
Price
$650.00
$600.00
$580.00
$570.00

$570.00
Revenues
$ 325,000.00
$ 456,000.00
$ 527,800.00
$ 655,500.00
$ 684,000.00
Initially, the MartinCo was able to sell the sensors at the price of $650/unit. Nonetheless, this
price has decreased to $570 per unit by 2014. Revenues had increased significantly over the five
years from $325,000 to over half a million dollars.
------------------------------------------
Operating (i.e. Indirect) Costs
MartinCo distributes its indirect cost to the business units, so the Image Processing unit is
responsible for its component of operating costs. For the first five years, the unit’s indirect costs
have been specified according to the following table.
Year
2011
2012
2013
2014
2015
Operating Costs
$ 78,600
$ 103,000
$ 114,000
$ 127,000
$ 140,000
------------------------------------------
Raw Materials
Mr. Martin was also able to compile the yearly raw material costs paid to the supplier since the
time the project was developed. Upon further analysis, Mr. Martin recognizes that the per-unit-
cost of raw materials are closely related to the number of sensors produced. Nonetheless, the raw
material costs for the first five years are shown in the following table.
Year
2011
2012

2013
2014
2015
Raw Materials
$ 80,000.00
$ 116,736.00
$ 134,125.00
$ 152,7910.00
$ 163,075.00
------------------------------------------
Direct Production Costs
Due to the uniqueness of his image processing sensor, Mr. Martin has very closely monitored the
direct production costs because of his concern with the high initial cost to produce the first
prototype. Since then, Mr. Martin has invested much of his time in mentoring and training the
production crew to help them become more efficient.
From his accounting data, Mr. Martin has been able to calculate that his total production costs
have increased from $136,328 to $259,637 over the past 5 years. Yearly sales/production has
however increased significantly in the same time period. By dividing the total direct labor costs
by the units produced, Mr. Martin is able to determine his average yearly unit cost. The average
per unit labor cost has decreased steadily from about $273/unit to about $216/unit. These
numbers are a great improvement over the $670 that it cost him to produce the first unit. Since
the operating or fixed costs are not included in this number, Mr. Martin concludes that there is
clearly a learning factor taking place, although he has not managed to figure out what to make of
these values.
Year
2011
2012
2013
2014
2015
Unit Sales
550
760
910
1150
1200

Production Costs
$ 136,328.17
$ 173,706.36
$ 203,507.66
$ 256,285.53
$ 259,637.01
Avg. Prod. Cost/Unit
$ 272.66
$ 228.56
$ 223.63
$ 222.86
$ 216.36
------------------------------------------
Interest and Taxes
MartinCo borrowed $60,000 to finance the venture to be repaid over 5 years at 6% interest.
MartinCo’s tax rate is 29% of taxable income and ordinary income. Tax rate is 15% for capital
gains.
------------------------------------------
Expansion
During the 2nd quarter of 2015, a buying agent for the Canikon approached Mr. Martin. The
buying agent proposed an exclusive selling agreement where Canikon would purchase all of Mr.
Martin’ Image Processing Sensors. Given the expanse of Canikon, a dramatic increase in sales is
expected for the business unit.
The buying agent was willing to commit to a 5 year purchase agreement with steadily increasing
sales from 3000 units in 2016, to 4200 units in 2020.
Year
2016
2017
2018
2019
2020
Unit Sales
3000
3600
4000
4200

4200
Price
$385.00
$385.00
$385.00
$385.00
$385.00
Revenues
$1,155,000
$1,386,000
$1,540,000
$1,617,000
$1,617,000
To allow for an operating and profit margin for Canikon, a fixed per-unit price of $385 paid by
the company to MartinCo would be a condition of the agreement. Mr. Martin is particularly
worried about the expansion at this point since he is unsure whether this would still allow him to
breakeven. After gathering additional information, Mr. Martin notes that:
He would have to estimate future costs to meet the demands of Canikon by relying on
information that he was able to gather from the first five years of operations.
He would have to replace the existing equipment. Mr. Martin estimates that he could get $38,000
in salvage for his existing machinery if he chooses to expand.
He would also need new equipments valued at $260,000 to be able to meet Canikon's demands.
Like the old equipment, the new machines would depreciate according to a 7-year MACRS
schedule.
For the expansion, Mr. Martin could get a loan of $100,000 at a 6% interest rate repayable over 5
years.
Following the 2015 production lot, Mr. Martin expects a 4% annual rate of reduction in the per-
unit cost of raw materials.
His tax rates would remain unchanged.
Year
2011
2012
2013
2014
2015

Unit Sales
550
760
910
1150
1200
Price
$650.00
$600.00
$580.00
$570.00
$570.00
Revenues
$ 325,000.00
$ 456,000.00
$ 527,800.00
$ 655,500.00
$ 684,000.00
Solution
Particulars
2011
2012
2013
2014
2015
Sales Units
500
760
910
1150
1200
Sales Price
650
600

580
570
570
Revenue
325,000
456,000
527,800
655,500
684,000
Raw Material Cost
80,000
116,736
134,125
157,910
163,075
Production Cost
136,328
173,706
203,508
256,286
259,637
Indirect Cost
78,600
103,000
114,000
127,000
140,000
Cost
294,928
393,442
451,633
541,196
562,712
EBDIT
30,072
62558

76167
117304
121288
Depreciation
25481
40501
24691
16839
10716
Interest
3600
3600
3600
3600
3600
EBT
991
18457
47876
93865
106972
Tax @ 29 % for ordinary income
287
5352
13884
27220
31022
Earnings after tax
704
13105
33992
66645
75950
Depreciation Schedule
Particular
2011

2012
2013
2014
2015
Total
Depreciation MACRS-7 Rate
14.29
24.49
17.49
12.49
8.93
Depreciation MACRS-3 Rate
33.33
44.45
14.81
7.41
Depreciation Equipment
17148
29388
20988
14988
10716
93,228
Depreciation Vehicle
8333
11113
3703
1851
25000
Total
25481
40501
24691
16839
10716
Tax on Sale of Equipment

Gross Cost
120,000
Accumulated Depreciation
93228
Net Book Value
26,772
Salvage Value
38,000
Gain ( Salvage Value- Net Value)
11228
Tax on Gain @ 29 %
3256
Net Cash Inflow
34,744
Cash Flow
Particular
2011
2012
2013
2014
2015
Net Income
704
13105
33992
66645
75950
Add- Depreciation
25481
40501
24691
16839
10716
Add: After Tax Salvage Value
34,744
Refund of Loan

-60,000
Cash Flow
26,185
53606
58683
83484
63410
Net Income and Cash Flow during the periods 2011 to 2015 shows a positive fiigure.
Particulars
2011
2012
2013
2014
2015
Sales Units
500
760
910
1150
1200
Sales Price
650
600
580
570
570
Revenue
325,000
456,000
527,800
655,500
684,000
Raw Material Cost
80,000
116,736
134,125

157,910
163,075
Production Cost
136,328
173,706
203,508
256,286
259,637
Indirect Cost
78,600
103,000
114,000
127,000
140,000
Cost
294,928
393,442
451,633
541,196
562,712
EBDIT
30,072
62558
76167
117304
121288
Depreciation
25481
40501
24691
16839
10716
Interest
3600
3600
3600

3600
3600
EBT
991
18457
47876
93865
106972
Tax @ 29 % for ordinary income
287
5352
13884
27220
31022
Earnings after tax
704
13105
33992
66645
75950