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TeeBee manufactures springs and related components for a variety of industrial and consumer end products. TB is...

TeeBee manufactures springs and related components for a variety of industrial and consumer end products. TB is evaluating a new business opportunity. In response to the growing health consciousness of the affluent aging baby boomer generation, a new concept in traction-associated exercise equipment is being developed. TB feels confident it can be a supplier of choice of the high quality springs needed for this new generation of equipment. TB has determined that its existing manufacturing facilities are not suitable for the manufacture of the type of spring needed. In order to evaluate whether to enter this market, TB needs to consider the return on investment in a new manufacturing facility. TB has identified two options for its potential new manufacturing site:

Option A: Renovation of an existing warehouse (economic life of 10 years)

Option B: Construction of a completely new facility (economic life of 20 years)

TB projects it will be able to sell 9,000 spring sets per year for the foreseeable future. Price per spring set is $699 (in year end 1 dollars). TB has employed a nominal discount rate of 9 percent on similar construction projects in the past. The following additional data have been collected. Assume all cash flows occur at the end of the year. Inflation is 3 percent per year.

	Option A	Option B

Construction costs*	$3,200,000	$10,000,000
Annual operating costs**
Fixed	$900,000**	$880,000**
Variable	$575/spring set	$525/spring set

*Assume all construction costs are incurred in period 0.

**Assume all these operating costs are incremental and represent cash flows. These operating cost projections apply to the first year of operations. Cash costs (as well as revenues) are expected to increase with inflation. Inflation applies initially in year 2.

Required: Prepare a financial analysis of the two options and make a recommendation. Use the income statement to net cash flow format, reflecting EBITDA, EBIT, EBIAT, and NCF. To see some of the implications of the changes to the tax code enacted in 2017, do your analysis under both the old and the new tax code regimes, as outlined below.

	old regime	new regime

Tax rate	35%	21%
Depreciation expense recognition**	Straight-line*	Year 1 100%**

*Straight line depreciation of construction costs over life of asset (term of project), no salvage value.

**Immediate expensing of construction costs. This change can most easily be accommodated by showing depreciation of 100% of the capital expenditure in year 1 of the project. Then, depreciation expense for the remaining years of the project is $0.

Expert Solution

i) Net present value of option A under old regime: ΣPresent value of cash flow = 1,179,436

No	Years	0	1	2	3	4	5	6	7	8	9	10
i	Sales (Previous year*1.03)		6,291,000	6,479,730	6,674,122	6,874,346	7,080,576	7,292,993	7,511,783	7,737,136	7,969,250	8,208,328
ii	Variable cost (9000*575)		5,175,000	5,175,000	5,175,000	5,175,000	5,175,000	5,175,000	5,175,000	5,175,000	5,175,000	5,175,000
iii	Fixed cost (Previous year*1.03)		900,000	927,000	954,810	983,454	1,012,958	1,043,347	1,074,647	1,106,886	1,140,093	1,174,296
iv	EBITDA (i-ii-iii)		216,000	377,730	544,312	715,892	892,618	1,074,646	1,262,136	1,455,250	1,654,157	1,859,032
v	Depreciation (3.2million/10)		320,000	320,000	320,000	320,000	320,000	320,000	320,000	320,000	320,000	320,000
vi	EBIT (iv-v)		-104,000	57,730	224,312	395,892	572,618	754,646	942,136	1,135,250	1,334,157	1,539,032
vii	Tax @ 35% (vi*0.35)		-36,400	20,206	78,509	138,562	200,416	264,126	329,748	397,338	466,955	538,661
viii	EBIAT (vi-vii)		-67,600	37,524	145,803	257,330	372,202	490,520	612,388	737,912	867,202	1,000,371
ix	Add back: Depreciation		320,000	320,000	320,000	320,000	320,000	320,000	320,000	320,000	320,000	320,000
x	NCF (viii+ix)		252,400	357,524	465,803	577,330	692,202	810,520	932,388	1,057,912	1,187,202	1,320,371
xi	Construction cost (Given)	-3,200,000
xii	Net cashflow (x+xi)	-3,200,000	252,400	357,524	465,803	577,330	692,202	810,520	932,388	1,057,912	1,187,202	1,320,371
xiii	PVF @ 9%	1	0.9174	0.8417	0.7722	0.7084	0.6499	0.5962	0.547	0.5018	0.4604	0.4224
xiv	Present value of cash flow (xii*xiii)	-3,200,000	231,552	300,928	359,693	408,981	449,862	483,232	510,016	530,860	546,588	557,725

ii) Net present value of option B under old regime: ΣPresent value of cash flow = 3,287,466

No	Years	0	1	2	3	4	5	6	7	8	9	10	11	12	13	14	15	16	17	18	19	20
i	Sales (Previous year*1.03)		6,291,000	6,479,730	6,674,122	6,874,346	7,080,576	7,292,993	7,511,783	7,737,136	7,969,250	8,208,328	8,454,578	8,708,215	8,969,461	9,238,545	9,515,701	9,801,172	10,095,207	10,398,063	10,710,005	11,031,305
ii	Variable cost (9000*525)		4,725,000	4,725,000	4,725,000	4,725,000	4,725,000	4,725,000	4,725,000	4,725,000	4,725,000	4,725,000	4,725,000	4,725,000	4,725,000	4,725,000	4,725,000	4,725,000	4,725,000	4,725,000	4,725,000	4,725,000
iii	Fixed cost (Previous year*1.03)		880,000	906,400	933,592	961,600	990,448	1,020,161	1,050,766	1,082,289	1,114,758	1,148,201	1,182,647	1,218,126	1,254,670	1,292,310	1,331,079	1,371,011	1,412,141	1,454,505	1,498,140	1,543,084
iv	EBITDA (i-ii-iii)		686,000	848,330	1,015,530	1,187,746	1,365,128	1,547,832	1,736,017	1,929,847	2,129,492	2,335,127	2,546,931	2,765,089	2,989,791	3,221,235	3,459,622	3,705,161	3,958,066	4,218,558	4,486,865	4,763,221
v	Depreciation (10million/20)		500,000	500,000	500,000	500,000	500,000	500,000	500,000	500,000	500,000	500,000	500,000	500,000	500,000	500,000	500,000	500,000	500,000	500,000	500,000	500,000
vi	EBIT (iv-v)		186,000	348,330	515,530	687,746	865,128	1,047,832	1,236,017	1,429,847	1,629,492	1,835,127	2,046,931	2,265,089	2,489,791	2,721,235	2,959,622	3,205,161	3,458,066	3,718,558	3,986,865	4,263,221
vii	Tax @ 35% (vi*0.35)		65,100	121,916	180,436	240,711	302,795	366,741	432,606	500,446	570,322	642,294	716,426	792,781	871,427	952,432	1,035,868	1,121,806	1,210,323	1,301,495	1,395,403	1,492,127
viii	EBIAT (vi-vii)		120,900	226,414	335,094	447,035	562,333	681,091	803,411	929,401	1,059,170	1,192,833	1,330,505	1,472,308	1,618,364	1,768,803	1,923,754	2,083,355	2,247,743	2,417,063	2,591,462	2,771,094
ix	Add back: Depreciation		500,000	500,000	500,000	500,000	500,000	500,000	500,000	500,000	500,000	500,000	500,000	500,000	500,000	500,000	500,000	500,000	500,000	500,000	500,000	500,000
x	NCF (viii+ix)		620,900	726,414	835,094	947,035	1,062,333	1,181,091	1,303,411	1,429,401	1,559,170	1,692,833	1,830,505	1,972,308	2,118,364	2,268,803	2,423,754	2,583,355	2,747,743	2,917,063	3,091,462	3,271,094
xi	Construction cost (given)	-10,000,000
xii	Net cashflow (x+xi)	-10,000,000	620,900	726,414	835,094	947,035	1,062,333	1,181,091	1,303,411	1,429,401	1,559,170	1,692,833	1,830,505	1,972,308	2,118,364	2,268,803	2,423,754	2,583,355	2,747,743	2,917,063	3,091,462	3,271,094
xiii	PVF @ 9%	1	0.9174	0.8417	0.7722	0.7084	0.6499	0.5962	0.547	0.5018	0.4604	0.4224	0.3875	0.3555	0.3261	0.2992	0.2745	0.2518	0.231	0.2119	0.1944	0.1783
xiv	Present value of cash flow (xii*xiii)	-10,000,000	569,614	611,423	644,860	670,880	690,410	704,166	712,966	717,273	717,842	715,053	709,321	701,155	690,799	678,826	665,320	650,489	634,729	618,126	600,980	583,236

iii) Net present value of option A under new regime: ΣPresent value of cash flow = 1,865,636

No	Years	0	1	2	3	4	5	6	7	8	9	10
i	Sales (Previous year*1.03)		6,291,000	6,479,730	6,674,122	6,874,346	7,080,576	7,292,993	7,511,783	7,737,136	7,969,250	8,208,328
ii	Variable cost (9000*575)		5,175,000	5,175,000	5,175,000	5,175,000	5,175,000	5,175,000	5,175,000	5,175,000	5,175,000	5,175,000
iii	Fixed cost (Previous year*1.03)		900,000	927,000	954,810	983,454	1,012,958	1,043,347	1,074,647	1,106,886	1,140,093	1,174,296
iv	EBITDA (i-ii-iii)		216,000	377,730	544,312	715,892	892,618	1,074,646	1,262,136	1,455,250	1,654,157	1,859,032
v	Depreciation		3,200,000
vi	EBIT (iv-v)		-2,984,000	377,730	544,312	715,892	892,618	1,074,646	1,262,136	1,455,250	1,654,157	1,859,032
vii	Tax @ 21% (vi*0.21)		-626,640	79,323	114,306	150,337	187,450	225,676	265,049	305,603	347,373	390,397
viii	EBIAT (vi-vii)		-2,357,360	298,407	430,006	565,555	705,168	848,970	997,087	1,149,647	1,306,784	1,468,635
ix	Add back: Depreciation		3,200,000
x	NCF (viii+ix)		842,640	298,407	430,006	565,555	705,168	848,970	997,087	1,149,647	1,306,784	1,468,635
xi	Construction cost (given)	-3,200,000
xii	Net cashflow (x+xi)	-3,200,000	842,640	298,407	430,006	565,555	705,168	848,970	997,087	1,149,647	1,306,784	1,468,635
xiii	PVF @ 9%	1	0.9174	0.8417	0.7722	0.7084	0.6499	0.5962	0.547	0.5018	0.4604	0.4224
xiv	Present value of cash flow (xii*xiii)	-3,200,000	773,038	251,169	332,051	400,639	458,289	506,156	545,407	576,893	601,643	620,351

iv) Net present value of option B under new regime: ΣPresent value of cash flow = 6,134,551

No	Years	0	1	2	3	4	5	6	7	8	9	10	11	12	13	14	15	16	17	18	19	20
i	Sales (Previous year*1.03)		6,291,000	6,479,730	6,674,122	6,874,346	7,080,576	7,292,993	7,511,783	7,737,136	7,969,250	8,208,328	8,454,578	8,708,215	8,969,461	9,238,545	9,515,701	9,801,172	10,095,207	10,398,063	10,710,005	11,031,305
ii	Variable cost (9000*525)		4,725,000	4,725,000	4,725,000	4,725,000	4,725,000	4,725,000	4,725,000	4,725,000	4,725,000	4,725,000	4,725,000	4,725,000	4,725,000	4,725,000	4,725,000	4,725,000	4,725,000	4,725,000	4,725,000	4,725,000
iii	Fixed cost (Previous year*1.03)		880,000	906,400	933,592	961,600	990,448	1,020,161	1,050,766	1,082,289	1,114,758	1,148,201	1,182,647	1,218,126	1,254,670	1,292,310	1,331,079	1,371,011	1,412,141	1,454,505	1,498,140	1,543,084
iv	EBITDA (i-ii-iii)		686,000	848,330	1,015,530	1,187,746	1,365,128	1,547,832	1,736,017	1,929,847	2,129,492	2,335,127	2,546,931	2,765,089	2,989,791	3,221,235	3,459,622	3,705,161	3,958,066	4,218,558	4,486,865	4,763,221
v	Depreciation		10,000,000
vi	EBIT (iv-v)		-9,314,000	848,330	1,015,530	1,187,746	1,365,128	1,547,832	1,736,017	1,929,847	2,129,492	2,335,127	2,546,931	2,765,089	2,989,791	3,221,235	3,459,622	3,705,161	3,958,066	4,218,558	4,486,865	4,763,221
vii	Tax @ 21% (vi*0.21)		-1,955,940	178,149	213,261	249,427	286,677	325,045	364,564	405,268	447,193	490,377	534,856	580,669	627,856	676,459	726,521	778,084	831,194	885,897	942,242	1,000,276
viii	EBIAT (vi-vii)		-7,358,060	670,181	802,269	938,319	1,078,451	1,222,787	1,371,453	1,524,579	1,682,299	1,844,750	2,012,075	2,184,420	2,361,935	2,544,776	2,733,101	2,927,077	3,126,872	3,332,661	3,544,623	3,762,945
ix	Add back: Depreciation		10,000,000
x	NCF (vii+ix)		2,641,940	670,181	802,269	938,319	1,078,451	1,222,787	1,371,453	1,524,579	1,682,299	1,844,750	2,012,075	2,184,420	2,361,935	2,544,776	2,733,101	2,927,077	3,126,872	3,332,661	3,544,623	3,762,945
xi	Construction cost (given)	-10,000,000
xii	Net cashflow (x+xi)	-10,000,000	2,641,940	670,181	802,269	938,319	1,078,451	1,222,787	1,371,453	1,524,579	1,682,299	1,844,750	2,012,075	2,184,420	2,361,935	2,544,776	2,733,101	2,927,077	3,126,872	3,332,661	3,544,623	3,762,945
xiii	PVF @ 9%	1	0.9174	0.8417	0.7722	0.7084	0.6499	0.5962	0.547	0.5018	0.4604	0.4224	0.3875	0.3555	0.3261	0.2992	0.2745	0.2518	0.231	0.2119	0.1944	0.1783
xiv	Present value of cash flow (xii*xiii)	-10,000,000	2,423,716	564,091	619,512	664,705	700,885	729,026	750,185	765,034	774,530	779,222	779,679	776,561	770,227	761,397	750,236	737,038	722,307	706,191	689,075	670,933

NPV	Option A	Option B
Old regime	1,179,436	3,287,466
New regime	1,865,636	6,134,551

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