Question

Bilbo Baggins is considering buying a company named Wind Resources (WR), which sells windmills all over Middle Earth. He has discovered, with Gandalf's help, a new way to manufacture wind turbines and wants to combine his new design with the production capabilities of WR. Over the last five years, Bilbo has spent countless time in the lab developing the design and has spent $200,000 on computer simulations and other research expenses. The purchase of WR will cost $500,000 plus an additional $500,000 of new eqiupment. It will also require an investment in working capital of $50,000. With the new designs, WR is expected to generate annual sales of $350,000 with associated expenses of $140,000. Assume the plant and equipment can be depreciated straight-line over 20 years, even though Bilbo expects to sell the plant to Frodo at the end of 5 years for $900,000. The firm's marginal tax rate is 35% and Bilbo's required rate of return for WR is 12%. Should he make the purchase?

Answer 1

He should not make the purcahse as NPV is negative of the project as per following table. Initial R& D expenses not to be includedin capital budgeting decision.

Initial investment on WR	500,000
Initial invesment on new equipments	500,000
Investment in WC	50,000
Sales		350000	350000	350000	350000	350000
Expenses		140,000	140,000	140,000	140,000	140,000
Depreciation		25000	25000	25000	25000	25000	Depreciation = (Equipment Cost -0)/20
EBT		185,000	185,000	185,000	185,000	185,000
Tax = EBT * Tax		64750	64750	64750	64750	64750
EAT = EBT -TAX		120,250	120,250	120,250	120,250	120,250
Add Depreciation		25,000	25,000	25,000	25,000	25,000	add depreciation
After Tax salvage Value						585000	After Tax salvage value = Salvage Value * ( 1- tax rate)
Operating Income	1,050,000	145,250	145,250	145,250	145,250	730,250
NPV using excel Function at 12% discount rate			-194,461.55	PV of all cash flows - initial investment

Bets of Luck. god Bless