Since East Coast Yachts is producing at full capacity, Larissa has decided to have Dan examine the feasibility of a new manufacturing plant. This expansion would represent a major capital outlay for the company. A preliminary analysis of the project has been conducted at a cost of $1.2 million. This analysis determined that the new plant will require an immediate outlay of $55 million and an additional outlay of $30 million in one year. The company has received a special tax dispensation that will allow the building and equipment to be depreciated on a 20-year MACRS schedule.
Because of the time necessary to build the new plant, no sales will be possible for the next year. Two years from now, the company will have partial-year sales of $18 million. Sales in the following four years will be $27 million, $35 million, $39 million, and $43 million. Because the new plant will be more efficient than East Coast Yachts’ current manufacturing facilities, variable costs are expected to be 60 percent of sales, and fixed costs will be $2.5 million per year. The new plant will also require net working capital amounting to 8 percent of following year’s.
Dan realizes that sales from the new plant will continue into the indefinite future. Because of this, he believes the cash flows after Year 5 will continue to grow at 3 percent indefinitely. The company’s tax rate is 40 percent and the required return is 11 percent.
Larissa would like Dan to analyze the financial viability of the new plant and calculate its profitability index, NPV, and IRR.
Task 4 Compute this project’s NPV, PI, and IRR. What should be Dan’s recommendation?
Guideline:
1. Use the trial-and-error method to find IRR. Note that we cannot use the Excel IRR function here. Using the terminal cash flow value in Year 5 as a cash flow in the IRR function is incorrect as the terminal cash flows have been discounted by the required return, which may be different from IRR.