in 2010 the bayside chemical company prepared the

Question

In 2010, the Bayside Chemical Company prepared the following analysis of an investment proposal for a new manufacturing facility:

 

Predicted 12% Present

Cash Year Present Value

Inflows of Cash Value of Cash

(Outflows) Flows Factor Flows

A B C (A) x (C)

Initial investment

Fixed assets.....................$(800,000) 0 1.000 $ (800,000)

Working capital..................(100,000) 0 1.000 (100,000)

Operations

Annual taxable income

Without depreciation............300,000 1-5 3.605 1,081,500

Taxes on income

($300,000x0.34)..................(102,000) 1-5 3.605 (367,710)

Depreciation tax shield............54,400* 1-5 3.605 196,112

Disinvestments

Site restoration......................80,000 5 0.567 (45,360)

Tax shield of restoration

($80,000x0.34).....................27,200 5 0.567 15,422

Working capital....................100,000 5 0.567 56,700

Net present value of all cash flows...............................................................$36,664

 

Because the proposal had a positive net present value when discounted at Bayside's cost of capital of 12percent, the project was approved; all investments were made at the end of 2011.

Shortly after production began in January 2012, a government agency notified Bayside of required additional expenditures totaling $200,000 to bring the plant into compliance with new federal emission regulations. Bayside has the option either to comply with the regulations by December 31, 2012, or to sell the entire operation (fixed assets and working capital) for $250,000 on December 31, 2012. The improvements will be depreciated over the next four-year life of the plant using straight-line depreciation. The cost of the site restoration will not be affected by the improvements. If Bayside elects to sell the plant, any book loss can be treated as an offset against taxable income on other operations. This tax deduction is an additional cash benefit of selling.

 

Required:

1. Should bay side sell the plant or comply with the new federal regulations? To simplify calculations, assume that any additional improvements are paid for on December 31, 2012.
2. Would Bayside have accepted the proposal in 2011 if it had been aware of the forthcoming federal regulations?
3. Do you have any suggestions that might increase the projects net present value? (No calculations).