Capital budgeting
Preface:
ABC Corp. is considering expanding its operations to include production and sales of high capacity storage devices. The assistant to the CFO has collected a lot of information which is described below. Unfortunately, some of the information may be of questionable relevance, but that is for you to decide. You have been asked to present a net present value based analysis to help management decide on the desirability of getting into the storage device business.
Company info:
The company owns land near its current manufacturing facility that could be used for the expansion. The land was purchased several years ago for $300,000, has a current market value of $400,000 and is not being used right now. The land is expected to increase in value at a rate of 5% per year.
The company has some unused equipment that it currently owns valued at $40,000. This equipment could either be sold or be modified to produce storage devices; the modification would cost $10,000. Producing storage devices would also require the purchase of new equipment costing $600,000. This new equipment, if purchased for $600,000, could be depreciated over a six-year useful life to a zero book value. At the end of its six year life the new equipment is likely to have a scrap value of 10% of the purchase price.
Producing storage devices would require an initial investment in working capital. Net working capital is expected to be 10% of expected sales for the coming year and would vary with sales, but remain at 10% of expected sales for the coming year. All working capital would be recovered at the end of the six-year life of the investment.
The production facility is expected to generate sales revenues of $600,000 in the first year, and sales are expected to increase by 10% per year through the six year life of the facility. Operating costs are expected to be 40% of sales. The firm’s effective tax rate of 25% is expected to remain unchanged over the planning period, and the appropriate required rate of return for this investment is 8%.
Tasks:
Estimate the net present value and the internal rate of return for this investment.
Now suppose the following changes occur: (i) Sales in the first year turn out to be $400,000, (ii) Revenue growth is 5% p.a. beyond year 1, (iii) Scrap value in year 6 is zero, and (iv) the required rate of return is 12%. What is the net present value and the internal rate of return with all four of the above changes?
Should ABC Corp. get into the storage device business?
Provide a recommendation and a short justification.
Numerical analysis: Suppose the firm decides to go ahead with this project. Lay out the incremental cash flows for each year, zero (i.e. today) through 6. Find the net present value of these cash flows.
Please make sure to explain why you include each data item that you include in the numerical analysis.