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 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%.

Tasks:

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

	Opportunity cost old Equipment	$30,000
	Modification cost	$10,000
	Cost of New equipment	$900,000
	Initial Net working capital	$100,000	(10%*1000000)
	Total	$1,040,000
						Tax Rate=	20%	0.2
			A	B=40%*A	C	D=C*(1-0.2)	E	F
			Sales	Operating Cost	Before tax	After Tax	Net Working	Working Capital
		Year	Revenue		Profit	Profit	Capital	Cash flow
		1	$1,000,000	$400,000	$600,000	$480,000	$110,000	($10,000)
		2	$1,100,000	$440,000	$660,000	$528,000	$121,000	($11,000)
		3	$1,210,000	$484,000	$726,000	$580,800	$133,100	($12,100)
		4	$1,331,000	$532,400	$798,600	$638,880	$126,445	$6,655
		5	$1,264,450	$505,780	$758,670	$606,936	$120,123	$6,322
		6	$1,201,228	$480,491	$720,737	$576,589	$0	$120,123
		Depreciation Tax shield
		MACRS -7 year
		New Equipment Cost=$900000						Tax Rate=20%
			A	B=A*$900000	C	D=40000/5	E=B+D	F=E*20%
			Depreciation	Amount of	Accumulated	Depreciation	Total	Depreciation
		Year	Rate	Depreciation	Depreciation	Old Equipment	Depreciation	Tax Shield
		1	14.29%	$128,610	$128,610	$8,000	$136,610	$27,322
		2	24.49%	$220,410	$349,020	$8,000	$228,410	$45,682
		3	17.49%	$157,410	$506,430	$8,000	$165,410	$33,082
		4	12.49%	$112,410	$618,840	$8,000	$120,410	$24,082
		5	8.93%	$80,370	$699,210	$8,000	$88,370	$17,674
		6	8.92%	$80,280	$779,490	$0	$80,280	$16,056
		Book Value at end of year 6		$120,510	(900000-779490)

MACRS-7 year New Equipment Cost $900000 B-A*$900000 Tax Rate 20 % E-B+D Depreciation Total Depreciation Depreciation Old Equipme Depreciation Tax Shield $8,000 F=E 20 % D-40000S Depreciation Amount of Accumulated Depreciation Year Rate $128,610 $128,610 $136.610 $27,322 14.29% $220,410 $349,020 $506,430 $8,000 $228,410 $45,682 $33,082 $24,082 $17,674 $16,056 24.49% 4 $8,000 $165,410 17.49% $157,410 $112,410 12.49 % 8.93 % $618,840 $8,000 $8,000 $120,410 - $80,370 $699,210 S6,570 $80,280 $0 8.92% Book Value at end of year6 S779,490 $120,510 (900000-779490) Terminal Cash Flow TOTAL Required Return-8 % -0.08 $90,000 (10%*9000000) $120,510 Sale of equipment Book value at end of 6 years G-B+C+D+E +F H-G/(1.08 A) Present value PV of cashflow D Loss on sale Working capitaTerminal Cashflow $30,510 $6,102 Depreciation Net Cash flow initial cash After Tax Tax saving on Loss(20 % ) flow 0 ($1,040,0001 profit Tax shield Cash Flow Year Terminal Cash Flow $96,102 (90000+6102) ($1,040,000) -$1.040,000 ($10,000) $27,322 $480,000 $497,322 $460.483 $528,000 $45,682 ($11,000 $562,682 $482.409 $580,800 $33,082 ($12,100 $601.782 $477,714 $638.880 $24.082 $6,655 $669,617 $492.188 $17.674 $630,932 $606.936 $6,322 $429.402 $576.589 $16.056 $120.123 $96.102 $808.870 $509,725 $1.811.922 SUM Net Present value (NPV) Internal Rate of Return $515985(Sum of PV of Cash Flows) 21.46% | ( using IRR function over the net cash flow)