What might be some of the considerations to be resolved when an FBO seeks financing for developments on leased airport land?
Nasco Heating Inc., a producer of heating equipment in Michigan, is currently evaluating the introduction of a new infrared space heater. Several of Nasco’s competitors have already entered the quartz infrared market in response to the public’s demand for heating devices that provide soft, moist, safe heat without reducing oxygen and humidity in the heated area. As a result, industry analysts predict high growth in the sales of infrared heaters in the years to come. Production facilities for the proposed project will be housed in a currently unused section of Nasco’s plant; this section was renovated last year at a cost of $150,000. Another local company has asked to lease this section of Nasco’s plant for $120,000 a year. The required production machinery costs $600,000; its shipping cost is estimated to be $10,000, while its installation cost is $40,000. The machinery falls in the 3-year MACRS class, has an economic life of four years, and its salvage value is estimated to be $100,000 after four years of use. In addition, Nasco must increase inventories by $120,000 at the time of the initial investment in the machinery. Thereafter, inventories should be three percent of annual revenues over the life of the project. Nasco expects to sell 400,000 units of the new heater in the first year of operations; thereafter unit sales are estimated to grow at a two percent annual rate. If the project is undertaken, production costs and selling price would be $48 and $55 per heater, respectively at current (t = 0) dollars; nevertheless, Nasco estimates that, beginning immediately, price will increase at the five percent inflation rate while production costs will increase by only two percent annually. Nasco’s sales manager is concerned that the introduction of the infrared heater will cannibalize the sales of the firm’s existing technology (i.e., radiant and ceramic) heaters. She estimates that existing heater sales will decline by $2,000,000 in the first year, dropping by an additional two percent annually thereafter. As a result, Nasco’s production manager estimates that existing heater production costs will decline by $500,000 in the first year, falling by an additional one percent annually thereafter. Nasco’s weighted average cost of capital (WACC) is 12 percent and its tax rate is 40 percent. 1.
1. You are in charge and expected to make a presentation to Nasco’s top-management regarding the merits of the infrared heater project. Given the base case information provided above, estimate its net cash flows over its life and provide measures of the project’s desirability or lack thereof. (Explain in detail your calculations for years 0 and 4.)
2. Once you have presented the above calculations, one of the firm’s VPs asks whether you used real cash flows discounted at a real rate, or nominal cash flows discounted at a nominal rate. Further, this VP asks you to demonstrate that either approach provides the same present value for the cash flow of year 4.