Desmond Troya, CEO of DESTROYA Pest Control, Inc. is weighing the purchase of new equipment, based on heat sensing technology, for termite inspections. The equipment will cost $156,000 including delivery and setup. It is expected to have a useful life of 5 years and will be depreciated using the MACRS percentages for a seven-year class life. After five years, the estimated disposal value of the equipment would be $15,600.
Adoption of the new inspection technology would require an investment in Net Working Capital equal to 15% of the following year's revenue from inspection services. For purposes of analysis, Mr. Troya assumes that this investment will occur at the beginning of each year (at t0 for yr 1, t1 for year 2, etc.). Falling sales would result in a positive cash flow from the partial liquidation of working capital. All net working capital will be recovered at the end of the project (year 5). DESTROYA estimates its average cost of capital (discount rate) at 10.5% and its marginal tax rate at 34%.
Most likely scenario:
Mr. Troya believes the equipment would be used to perform 960 inspections the first year. Customers would be charged $150 for an inspection. Labor, supplies and other direct, cash costs per inspection would be $75. DESTROYA would also have $20,000 per year in fixed costs directly associated with this project. Fixed costs would stay the same throughout the five years. Troya believes that the number of inspections would probably increase by 5% per year; the price of an inspection and direct, variable costs would also increase by 5% per year.
Best case scenario:
Same as the most likely scenario except that 1050 inspections are performed in the first year and the number of inspections performed increases at the rate of 10% per year for the remaining four years.
Worst case scenario:
960 inspections are performed in the first year, but competitors purchase the same technology causing unit sales and price to fall by 5% per year. Direct variable costs, on the other hand, still rise at the rate of 5% per year.
Required:
1. Compute a separate schedule of cash flows (investment, operating and terminal, if any) for each scenario of the expansion project.
2. For each scenario, compute payback, net present value, and internal rate of return.
3. Make a recommendation whether or not to go ahead with the project. Consider all three scenarios. You have subjectively estimated the probability of the best and worst case scenarios at 25% and 50% for most likely case. Explain your decision. Keep in mind that scenarios happen, they cannot be chosen in advance.