Question

Benson Enterprises is evaluating alternative uses for a three-story manufacturing and warehousing building that it has purchased for $1,550,000. The company can continue to rent the building to the present occupants for $71,000 per year. The present occupants have indicated an interest in staying in the building for at least another 15 years. Alternatively, the company could modify the existing structure to use for its own manufacturing and warehousing needs. Benson’s production engineer feels the building could be adapted to handle one of two new product lines. The cost and revenue data for the two product alternatives are as follows:

	Product A		Product B
Initial cash outlay for building modifications	$	105,000	$	135,000
Initial cash outlay for equipment		205,000		240,000
Annual pretax cash revenues (generated for 15 years)		198,000		235,000
Annual pretax expenditures (generated for 15 years)		80,000		100,000

The building will be used for only 15 years for either Product A or Product B. After 15 years the building will be too small for efficient production of either product line. At that time, Benson plans to rent the building to firms similar to the current occupants. To rent the building again, Benson will need to restore the building to its present layout. The estimated cash cost of restoring the building if Product A has been undertaken is $65,000. If Product B has been manufactured, the cash cost will be $90,000. These cash costs can be deducted for tax purposes in the year the expenditures occur.

Benson will depreciate the original building shell over a 30-year life to zero, regardless of which alternative it chooses. The building modifications and equipment purchases for either product are estimated to have a 15-year life. They will be depreciated by the straight-line method. The firm’s tax rate is 34 percent, and its required rate of return on such investments is 10 percent.
  
Assume all cash flows occur at the end of the year. The initial outlays for modifications and equipment will occur today (Year 0), and the restoration outlays will occur at the end of Year 15.

What is the NPV of the decision to continue to rent? (Do not round intermediate calculations and round your answer to 2 decimal places, e.g., 32.16.)

NPV           $

What is the NPV for modifying the building to manufacture Product A? (Do not round intermediate calculations and round your answer to 2 decimal places, e.g., 32.16.)
  
NPV           $

What is the NPV for modifying the building to manufacture Product B? (Do not round intermediate calculations and round your answer to 2 decimal places, e.g., 32.16.)

NPV           $

Answer 1

NPV (Net Present value) = Present value of cash inflows - Present value of cash outflows

Working notes:

1. Cost of building $15,50,000 is not considered in present value of cash outflows, since it has already been incurred and is a sunk cost. The selection of alternatives does not impact this cost.

2. Annual depreciation on building under straight-line method= $1,550,000/30 = $51,666.67

3. Annual depreciation on building modifications and equipment for Product A = ($105,000 + $205,000)/15 = $20,666.67

4. Annual depreciation on building modifications and equipment for Product B = ($135,000 + $240,000)/15 = $25,000

5. Present value interest factor is calculated at cost of capital 10% as 1/(1+0.10)^1 for Year 1, 1/(1+0.10)^2 for Year 2, 1/(1+0.10)^3 for Year 3 and so on till 1/(1+0.10)^15 for Year 15.

6. NPV (Net Present Value) = Sum of present value of all cash inflows - Sum of present value of all cash outflows.

Rent the building	Year 0	Year 1	Year 2	Year 3	Year 4	Year 5	Year 6	Year 7	Year 8	Year 9	Year 10	Year 11	Year 12	Year 13	Year 14	Year 15
Annual rent revenue		$71,000.00	$71,000.00	$71,000.00	$71,000.00	$71,000.00	$71,000.00	$71,000.00	$71,000.00	$71,000.00	$71,000.00	$71,000.00	$71,000.00	$71,000.00	$71,000.00	$71,000.00
Less: Depreciation		$51,666.67	$51,666.67	$51,666.67	$51,666.67	$51,666.67	$51,666.67	$51,666.67	$51,666.67	$51,666.67	$51,666.67	$51,666.67	$51,666.67	$51,666.67	$51,666.67	$51,666.67
Net income before tax		$19,333.33	$19,333.33	$19,333.33	$19,333.33	$19,333.33	$19,333.33	$19,333.33	$19,333.33	$19,333.33	$19,333.33	$19,333.33	$19,333.33	$19,333.33	$19,333.33	$19,333.33
Less: Tax @34%		$6,573.33	$6,573.33	$6,573.33	$6,573.33	$6,573.33	$6,573.33	$6,573.33	$6,573.33	$6,573.33	$6,573.33	$6,573.33	$6,573.33	$6,573.33	$6,573.33	$6,573.33
Profit After tax		$12,760.00	$12,760.00	$12,760.00	$12,760.00	$12,760.00	$12,760.00	$12,760.00	$12,760.00	$12,760.00	$12,760.00	$12,760.00	$12,760.00	$12,760.00	$12,760.00	$12,760.00
Add back: Depreciation		$51,666.67	$51,666.67	$51,666.67	$51,666.67	$51,666.67	$51,666.67	$51,666.67	$51,666.67	$51,666.67	$51,666.67	$51,666.67	$51,666.67	$51,666.67	$51,666.67	$51,666.67
Net cash flows		$64,426.67	$64,426.67	$64,426.67	$64,426.67	$64,426.67	$64,426.67	$64,426.67	$64,426.67	$64,426.67	$64,426.67	$64,426.67	$64,426.67	$64,426.67	$64,426.67	$64,426.67
PVIF @10%		0.9091	0.8264	0.7513	0.6830	0.6209	0.5645	0.5132	0.4665	0.4241	0.3855	0.3505	0.3186	0.2897	0.2633	0.2394
Present value of cash flows		$58,569.70	$53,245.18	$48,404.71	$44,004.28	$40,003.89	$36,367.17	$33,061.07	$30,055.52	$27,323.20	$24,839.27	$22,581.15	$20,528.32	$18,662.11	$16,965.56	$15,423.23
NPV	$490,034.36

Manufacture Product A	Year 0	Year 1	Year 2	Year 3	Year 4	Year 5	Year 6	Year 7	Year 8	Year 9	Year 10	Year 11	Year 12	Year 13	Year 14	Year 15
Initial cash outlay for building modifications	$105,000.00
Initial cash outlay for equipment	$205,000.00
Annual pre-tax cash revenue		$198,000.00	$198,000.00	$198,000.00	$198,000.00	$198,000.00	$198,000.00	$198,000.00	$198,000.00	$198,000.00	$198,000.00	$198,000.00	$198,000.00	$198,000.00	$198,000.00	$198,000.00
Less: Annual pre tax exp		$80,000.00	$80,000.00	$80,000.00	$80,000.00	$80,000.00	$80,000.00	$80,000.00	$80,000.00	$80,000.00	$80,000.00	$80,000.00	$80,000.00	$80,000.00	$80,000.00	$80,000.00
Less: Depreciation on building		$51,666.67	$51,666.67	$51,666.67	$51,666.67	$51,666.67	$51,666.67	$51,666.67	$51,666.67	$51,666.67	$51,666.67	$51,666.67	$51,666.67	$51,666.67	$51,666.67	$51,666.67
Less: Depreciation on building modifications and equipment		$20,666.67	$20,666.67	$20,666.67	$20,666.67	$20,666.67	$20,666.67	$20,666.67	$20,666.67	$20,666.67	$20,666.67	$20,666.67	$20,666.67	$20,666.67	$20,666.67	$20,666.67
Less: Restoration costs		$0.00	$0.00	$0.00	$0.00	$0.00	$0.00	$0.00	$0.00	$0.00	$0.00	$0.00	$0.00	$0.00	$0.00	$65,000.00
Net income before tax		$45,666.66	$45,666.66	$45,666.66	$45,666.66	$45,666.66	$45,666.66	$45,666.66	$45,666.66	$45,666.66	$45,666.66	$45,666.66	$45,666.66	$45,666.66	$45,666.66	-$19,333.34
Less: Tax @34%		$15,526.67	$15,526.67	$15,526.67	$15,526.67	$15,526.67	$15,526.67	$15,526.67	$15,526.67	$15,526.67	$15,526.67	$15,526.67	$15,526.67	$15,526.67	$15,526.67	-$6,573.33
Profit After tax		$30,140.00	$30,140.00	$30,140.00	$30,140.00	$30,140.00	$30,140.00	$30,140.00	$30,140.00	$30,140.00	$30,140.00	$30,140.00	$30,140.00	$30,140.00	$30,140.00	-$12,760.00
Add back: Depreciation		$72,333.34	$72,333.34	$72,333.34	$72,333.34	$72,333.34	$72,333.34	$72,333.34	$72,333.34	$72,333.34	$72,333.34	$72,333.34	$72,333.34	$72,333.34	$72,333.34	$72,333.34
Net cash flows		$102,473.33	$102,473.33	$102,473.33	$102,473.33	$102,473.33	$102,473.33	$102,473.33	$102,473.33	$102,473.33	$102,473.33	$102,473.33	$102,473.33	$102,473.33	$102,473.33	$59,573.33
PVIF @10%		0.9091	0.8264	0.7513	0.6830	0.6209	0.5645	0.5132	0.4665	0.4241	0.3855	0.3505	0.3186	0.2897	0.2633	0.2394
Present value of cash flows		$93,157.58	$84,688.71	$76,989.73	$69,990.67	$63,627.88	$57,843.53	$52,585.02	$47,804.57	$43,458.70	$39,507.91	$35,916.28	$32,651.16	$29,682.87	$26,984.43	$14,261.38
Total Present value of cash inflows	$769,150.41
NPV	$459,150.41

Manufacture Product B	Year 0	Year 1	Year 2	Year 3	Year 4	Year 5	Year 6	Year 7	Year 8	Year 9	Year 10	Year 11	Year 12	Year 13	Year 14	Year 15
Initial cash outlay for building modifications	$135,000.00
Initial cash outlay for equipment	$240,000.00
Annual pre-tax cash revenue		$235,000.00	$235,000.00	$235,000.00	$235,000.00	$235,000.00	$235,000.00	$235,000.00	$235,000.00	$235,000.00	$235,000.00	$235,000.00	$235,000.00	$235,000.00	$235,000.00	$235,000.00
Less: Annual pre tax exp		$100,000.00	$100,000.00	$100,000.00	$100,000.00	$100,000.00	$100,000.00	$100,000.00	$100,000.00	$100,000.00	$100,000.00	$100,000.00	$100,000.00	$100,000.00	$100,000.00	$100,000.00
Less: Depreciation on building		$51,666.67	$51,666.67	$51,666.67	$51,666.67	$51,666.67	$51,666.67	$51,666.67	$51,666.67	$51,666.67	$51,666.67	$51,666.67	$51,666.67	$51,666.67	$51,666.67	$51,666.67
Less: Depreciation on building modifications and equipment		$25,000.00	$25,000.00	$25,000.00	$25,000.00	$25,000.00	$25,000.00	$25,000.00	$25,000.00	$25,000.00	$25,000.00	$25,000.00	$25,000.00	$25,000.00	$25,000.00	$25,000.00
Less: Restoration costs		$0.00	$0.00	$0.00	$0.00	$0.00	$0.00	$0.00	$0.00	$0.00	$0.00	$0.00	$0.00	$0.00	$0.00	$90,000.00
Net income before tax		$58,333.33	$58,333.33	$58,333.33	$58,333.33	$58,333.33	$58,333.33	$58,333.33	$58,333.33	$58,333.33	$58,333.33	$58,333.33	$58,333.33	$58,333.33	$58,333.33	-$31,666.67
Less: Tax @34%		$19,833.33	$19,833.33	$19,833.33	$19,833.33	$19,833.33	$19,833.33	$19,833.33	$19,833.33	$19,833.33	$19,833.33	$19,833.33	$19,833.33	$19,833.33	$19,833.33	-$10,766.67
Profit After tax		$38,500.00	$38,500.00	$38,500.00	$38,500.00	$38,500.00	$38,500.00	$38,500.00	$38,500.00	$38,500.00	$38,500.00	$38,500.00	$38,500.00	$38,500.00	$38,500.00	-$20,900.00
Add back: Depreciation		$76,666.67	$76,666.67	$76,666.67	$76,666.67	$76,666.67	$76,666.67	$76,666.67	$76,666.67	$76,666.67	$76,666.67	$76,666.67	$76,666.67	$76,666.67	$76,666.67	$76,666.67
Net cash flows		$115,166.67	$115,166.67	$115,166.67	$115,166.67	$115,166.67	$115,166.67	$115,166.67	$115,166.67	$115,166.67	$115,166.67	$115,166.67	$115,166.67	$115,166.67	$115,166.67	$55,766.67
PVIF @10%		0.9091	0.8264	0.7513	0.6830	0.6209	0.5645	0.5132	0.4665	0.4241	0.3855	0.3505	0.3186	0.2897	0.2633	0.2394
Present value of cash flows		$104,696.97	$95,179.06	$86,526.42	$78,660.38	$71,509.44	$65,008.58	$59,098.71	$53,726.10	$48,841.91	$44,401.74	$40,365.21	$36,695.65	$33,359.68	$30,326.98	$13,350.10
Total Present value of cash inflows	$861,746.94
NPV	$486,746.94