Question

B&B Technologies is considering expanding its operations to include production and sales of high capacity storage devices. The assistant to the CFO has collected a lot of information which is described below. Unfortunately, some of the information may be of questionable relevance, but that is for you to decide. You have asked to present a net present value based analysis to help management decide on the desirability of getting into the storage device business.

The company owns a vacant building near its current manufacturing facility; this building could be used for the expansion, or it could be leased to an interested customer and generate a lease revenue of $250,000, starting this year. The firm could increase the lease charge by 5% every year. The company has some unused equipment that has a book value of $40,000 zero and a market value of $30,000. This equipment could either be sold or be modified to produce storage devices; the modification would cost $10,000. The old equipment and modification costs would be depreciated straight-line over five years. Producing storage devices would also require the purchase of new equipment costing $900,000. For purposes of depreciation, the new equipment would be in the 7-year MACRS class. This equipment would have a useful life of six years, at the end of which it would have a scrap value of 10% of the purchase price.

Producing storage devices would require an ongoing investment in working capital. Net working capital is expected to be 10% of expected sales for the coming year and would vary with sales, but remain at 10% of expected sales for the coming year. All working capital would be recovered at the end of the six-year life of the investment.

The production facility is expected to generate sales revenues of $1,000,000 in the first year; sales are expected to increase at 10% p.a. for three years and then decline by 5% p.a. over the last two years of the project. Operating costs are expected to be 40% of sales. The firm’s effective tax rate of 20% is expected to remain unchanged over the planning period, and the appropriate required rate of return for this investment is 8%.

Question

1. Estimate the net present value and the internal rate of return for this investment.

2. Now suppose the following changes occur: (i) Sales in the first year turn out to be $900,000, (ii) the CGS to sales ratio is 45%, (iii) the NWC to sales ratio is 15%, (iv) the scrap value of the new equipment in year 6 is 5% of the original cost, and (v) the required rate of return is 10%. What is the net present value and the internal rate of return with all of the above changes? Should B&B Technologies get into the storage device business?

Answer 1

1). NPV = 522,932.13

IRR = 14.56%

Depreciation schedule:

Initial investment:

NPV & IRR:

2). NPV = -54,961.49

IRR = 9.24%

Under these conditions, the project should not be accepted as it is loss making.

Depreciation schedule remains the same as in part (1).

Initial investment:

NPV & IRR analysis: