Proposal 1
The current plant has a capacity of 25,000 cases per month. The first proposal is for a major expansion that would double the plant’s current capacity to 50,000 cases per month. After talking with the firm’s design engineers, sales managers, and plant operators, you have prepared the following estimates:
Expanding the plant will require the purchase of $3.6 million in new equipment, and entail up-front design and engineering expenses of $3.9 million. These costs will be paid immediately when the expansion begins.
Installing the new equipment and redesigning the plant to accommodate the higher capacity will require shutting down the plant for nine months. During that time, the plant’s production will cease. After the expansion is finished, the plant will operate at double its original capacity.
Marketing and selling the additional volume will lead to $1 million per year in additional sales, marketing, and administrative costs. These costs will begin in the first year (even while the plant is under construction and shut down).
Proposal 2
The engineers have put forth a second proposal for a minor expansion that will increase the firm’s capacity by only 50%, to 37,500 cases per month. While the capacity is smaller, such an expansion would be cheaper and less disruptive:
The smaller expansion will require only $2.4 million in new equipment, and $1.5 million in design and engineering expenses.
The existing plant will need to be shut down for only four months.
Sales, marketing, and administrative costs will only increase by $500,000.
Nanovo believes that with or without any expansion, the technology used at the plant will be obsolete after six years and will have no salvage value, and the plant itself will need to be completely overhauled at that time. You also have the following additional general information:
With or without either proposed expansion, Nanovo will be able to sell all it can produce at an average wholesale price of $80 per case. This price is not expected to change during the next six years.
Nanovo has a gross profit margin of 55% on these batteries.
Nanovo’s average net working capital at the end of each year will equal 15% of its annual revenue.
Nanovo pays a 40% corporate tax rate. While all design and engineering costs are immediately deductible as operating expenses, all capital expenditures will be straight-line depreciated for tax purposes over the subsequent six years.
Management believes the risk of the expansion is similar to the risk of Nanovo’s existing projects, and because
Nanovo is all equity financed, the risk of the expansion is also similar to the risk of Nanovo stock. You have the following additional information about the stock:
Nanovo has no debt and has 2 million shares outstanding. The firm’s current share price is $75 per share.
Analysts are expecting Nanovo to pay a $3 dividend at the end of this year, and to raise its dividend at an average rate of 8% per year in the future.
Based on this information, you have been tasked with preparing expansion recommendations for Nanovo (using Excel is optional but recommended).
1. Determine the annual incremental free cash flow associated with each expansion proposal relative to the status quo (no expansion).
2. Compute the IRR and payback period of each expansion proposal. Which plan has a higher IRR? Which has a shorter payback period?