Question

The Rubio’s Fantastic Cs is a medium-size, Los Angeles based company that has been in business for the last ten years. It specializes in manufacturing the air conditioners. Over the last two years, the Rubio’s has spent $20,000 developing a new energy efficient and eco-friendly air conditioner called EcoStar.

Suppose you are a financial consultant advising the Rubio’s on whether to build a new plant in San Diego that will manufacture the EcoStar. The current date is December 31, 2017. The plant will be built over the two years and will be ready to start production on January 1, 2020. The plant is expected to operate only for the two years and so it will cease production on December 31, 2021. The investment for the plant requires an outlay of $10 million to be paid at the end of 2017 year. The IRS rules prescribe that this expenditure is depreciated using the straight-line depreciation schedule (to 0$) over five years as soon as the plant starts producing. The plant is expected to be reselled for $5 million on December 31, 2021. The plant will be built on the land that could be rented out for $375,000 a year.

To launch the manufacture of the EcoStar, the firm would also need to acquire new equipment. The equipment will cost $1 million to be paid at the end of 2019 year and will be depreciated using the straight line depreciation over the two years the plant is manufacturing the EcoStar. After two-years of the manufacture the equipment has no salvage value.

The Fabio’s new plant will produce 100,000 air conditioners a year. The EcoStar air conditioner can be sold at $500 per unit. Raw materials costs are $220 per unit and total labor costs are $500,000 a year. These revenues and costs are expected to be the same for the two year the plant is producing.

The working capital required on December 31, 2019 to allow inventories to be financed during the first year of productions is $100,000. Working capital needs for the second year will be $200,000. When the plant ceases manufacture all the working capital will be recovered (i.e. working capital equals $0 on December 31, 2021).

The Rubio’s Fantastic Cs has a corporate tax rate of 20% and other profitable ongoing operations. The opportunity cost of capital for this kind of project is 10%.

What is the NPV of the project?

Should the firm build the plant and start manufacturing the EcoStar?

Answer 1

NPV of the project = ΣPresent value of cashflow = 24,572,530

EcoStar project gives positive NPV, hence the firm should build the plant and start manufacturing.

Sl.No	Year	2017	2018	2019	2020	2021	2022	2023	2024
i	Revenue (100,000*500)				50,000,000	50,000,000
ii	Raw materials (100,000*220)				22,000,000	22,000,000
iii	Labor costs (given)				500,000	500,000
iv	Depreciation (Note.1)				2,500,000	2,500,000	2,000,000	2,000,000	2,000,000
v	EBIT (i-ii-iii-iv)				25,000,000	25,000,000	(2,000,000)	(2,000,000)	(2,000,000)
vi	Taxes @ 20% (v*20%) (Negative indicates tax savings)				5,000,000	5,000,000	(400,000)	(400,000)	(400,000)
vii	Profit after tax (v-vi)				20,000,000	20,000,000	(1,600,000)	(1,600,000)	(1,600,000)
viii	Add back: Depreciation				2,500,000	2,500,000	2,000,000	2,000,000	2,000,000
ix	Operating cashflow (vii+viii)				22,500,000	22,500,000	400,000	400,000	400,000
x	Investment in plant (given)	(10,000,000)
xi	Resale value of plant (given)					5,000,000
xii	Opportunity cost after tax (375000*[1-tax rate])		(300,000)	(300,000)	(300,000)	(300,000)
xiii	Equipment cost (given)			(1,000,000)
xiv	Net increase in working capital (given)			(100,000)	(100,000)	200,000
xv	Net cashflow (ix+x+xi+xii+xiii+xiv)	(10,000,000)	(300,000)	(1,400,000)	22,100,000	27,400,000	400,000	400,000	400,000
xvi	PVF @ 10%	1	0.9091	0.8265	0.7514	0.6831	0.621	0.5645	0.5132
xvii	Present value of cashflow (xv*xvi)	(10,000,000)	(272,730)	(1,157,100)	16,605,940	18,716,940	248,400	225,800	205,280

Note 1)

Depreciation for year 2020 & 2021 = cost of plant/5years+cost of machine/2years = (10million/5)+(1million/2) = 2million+0.5million = 2.5million

Depreciation for year 2022, 2023 & 2024 = cost of plant/5years = (10million/5) = 2million