Question

Since East Coast Yachts is producing at full capacity, Larissa has decided to have Dan examine the feasibility of a new manufacturing plant. This expansion would represent a major capital outlay for the company. A preliminary analysis of the project has been conducted at a cost of $1.2 million. This analysis determined that the new plant will require an immediate outlay of $55 million and an additional outlay of $30 million in one year. The company has received a special tax dispensation that will allow the building and equipment to be depreciated on a 20-year MACRS schedule. Because of the time necessary to build the new plant, no sales will be possible for the next year. Two years from now, the company will have partial-year sales of $18 million. Sales in the following four years will be $27 million, $35 million, $39 million, and $43 million. Because the new plant will be more efficient than East Coast Yachts’ current manufacturing facilities, variable costs are expected to be 60 percent of sales, and fixed costs will be $2.5 million per year. The new plant will also require net working capital amounting to 8 percent of sales for the next year. Dan realizes that sales from the new plant will continue into the indefinite future. Because of this, he believes the cash flows after Year 5 will continue to grow at 3 percent indefinitely. The company’s tax rate is 40 percent and the required return is 11 percent. Larissa would like Dan to analyze the financial viability of the new plant and calculate the profitability index, NPV, and IRR. Also, Larissa has instructed Dan to disregard the value of the land that the new plant will require. East Coast Yachts already owns it, and, as a practical matter, it will simply go unused indefinitely. She has asked Dan to discuss this issue in his report.

Answer 1

		Initial Costs:
		Preliminary analysis	$1,200,000
		Immediate outlay	$55,000,000
		Cash outflow in year 0	$56,200,000
		Present Value(PV) of Cash flow=(Cash Flow)/(1+i)^N
		i=discount rate=required return=11%	0.11
		N= Year of cash flow
		YEAR WISE CASH FLOW GIVEN BELOW:
	N	Year	0	1	2	3	4	5	6	7
	A	Initial cash flow	($56,200,000)
	B	Additional outlay		($30,000,000)
	C	MACRS Depreciation rate		3.750%	7.219%	6.677%	6.177%	5.713%	5.215%
	D=C*$55million	Annual Depreciation of immediate outlay		$        2,062,500	$     3,970,450	$     3,672,350	$     3,397,350	$   3,142,150	$       2,868,250
	E	Annual Depreciation of immediate outlay			$     1,125,000	$     2,165,700	$     2,003,100	$   1,853,100	$       1,713,900
	F=D+E	Total Depreciation expense		$        2,062,500	$     5,095,450	$     5,838,050	$     5,400,450	$   4,995,250	$       4,582,150
	G=F*0.4	Depreciation tax shield		$            825,000	$     2,038,180	$     2,335,220	$     2,160,180	$   1,998,100	$       1,832,860
	H	Sales			$18,000,000	$27,000,000	$35,000,000	$39,000,000	$43,000,000	$44,290,000
	I=0.6*H	Variable costs			$10,800,000	$16,200,000	$21,000,000	$23,400,000	$25,800,000
	J	Fixed Costs			$2,500,000	$2,500,000	$2,500,000	$2,500,000	$2,500,000
	K=H-I-J	Before tax income excluding depreciation			$4,700,000	$8,300,000	$11,500,000	$13,100,000	$14,700,000
	L=K*(1-0.4)	After tax income excluding depreciation			$2,820,000	$4,980,000	$6,900,000	$7,860,000	$8,820,000
	M=G+L	After tax Cash Flow		$            825,000	$     4,858,180	$     7,315,220	$     9,060,180	$   9,858,100	$    10,652,860
	O	Working Capital requirement		$1,440,000	$2,160,000	$2,800,000	$3,120,000	$3,440,000	$3,543,200
	P	Net Cash flow for working capital		($1,440,000)	($720,000)	($640,000)	($320,000)	($320,000)	($103,200)
	Q=A+B+M+P	Total Cash Flow	($56,200,000)	($30,615,000)	$4,138,180	$6,675,220	$8,740,180	$9,538,100	$10,549,660	$10,866,150
	R=10866150/(0.11-0.03)	Value of Perpetual cash flow growing at 3%							$ 135,826,873
	S=Q+R	Total Cash flow including perpetual cash flow	($56,200,000)	($30,615,000)	$4,138,180	$6,675,220	$8,740,180	$9,538,100	$146,376,533	SUM
	PV=S/(1.11^N)	Present value of Cash flow	$(56,200,000)	$   (27,581,081)	$     3,358,640	$     4,880,863	$     5,757,427	$   5,660,398	$    78,258,872	$     14,135,119
		Net Present Value (NPV)=SUM OF PV OF CASH FLOWS
		NPV=	$   14,135,119
		Profitability Index=(NPV +Initial outlay)/Initial outlay
		Profitability Index=	1.17	(14135119+56200000+27581081)/(56200000+27581081)
		Iinternal rate of Return (IRR)	14.38%	(Using IRR function of excel over the cash flow)