Question

Kingston Kiteboards Incorporated (KKI) has been experiencing very strong demand for its products as kite-boarding continues to take away market share from windsurfing. The company is considering a new facility to manufacture an improved line of kites and another facility to produce a new line of boards. The company estimates that the new kite facility will cost $1,350,000 to construct in Year 0 with a salvage value of $160,000 in Year 15. The board manufacturing facility will cost $1,700,000 in Year 0 with a salvage value of $180,000 in Year 15. Combined annual revenue for the new kites and boards is expected to be $750,000 with annual combined operating costs of $270,000 each year. Management has identified a piece of land where both facilities could be built that could be purchased for $550,000 in Year 0. The management team estimates that the land may be sold for the same value of $550,000 at the end of Year 15. The company uses a discount rate of 9% and a tax rate of 30%. Assume that the CCA rate of 20% can be applied to the land and the manufacturing facilities

a. Use the present value tax shield approach to determine the NPV of combined project involving both new manufacturing facilities. Should KKI proceed with the investment using these assumptions?

b. The management team at KKI has decided to take a more conservative approach with some of its estimates. The team feels that the facilities may only last for 13 years and the operating costs may amount to $300,000 per year. However, the company has successfully negotiated a construction cost of $1,200,000 for the kite facility and $1,400,000 for the board facility. (Assume the salvage values are unchanged.) Using the present value tax shield approach, what is the total NPV with these assumptions? Should the company proceed under these revised assumptions?

Answer 1

Given Information:
Cash Outflows at year 0
Manufacturing Kite Facility	$1,350,000
Manufacturing Board Facility	$1,700,000
Land Cost	$55,000
Salvage value at year 15
Kite facility	$160,000
Board Facility	$180,000
Land	$550,000
Cash Inflow (Per Annum)
Combined Revenue	$750,000
Combined operating costs	$270,000
Profit before CCA & TAX	$480,000
General Info
Discount Rate	9%
CCA	20%
Tax Rate	30%

Case a.

	Years
	1	2	3	4	5	6	7	8	9	10	11	12	13	14	15
Profit before CCA & Tax	480000	480000	480000	480000	480000	480000	480000	480000	480000	480000	480000	480000	480000	480000	480000
Less: CCA on land	110000	110000	110000	110000	110000	0	0	0	0	0	0	0	0	0	0
CCA on Kite facility	270000	270000	270000	270000	270000	0	0	0	0	0	0	0	0	0	0
CCA on Board Facility	340000	340000	340000	340000	340000	0	0	0	0	0	0	0	0	0	0
Profit before TAX	-240000	-240000	-240000	-240000	-240000	480000	480000	480000	480000	480000	480000	480000	480000	480000	480000
Less:TAX	0	0	0	0	0	144000	144000	144000	144000	144000	144000	144000	144000	144000	144000
Profit after tax	-240000	-240000	-240000	-240000	-240000	336000	336000	336000	336000	336000	336000	336000	336000	336000	336000
Cash inflow	480000	480000	480000	480000	480000	336000	336000	336000	336000	336000	336000	336000	336000	336000	336000
Salvage value (after tax)
Kite facility															160000
Board facility															180000
Land															550000
Net cash flow	480000	480000	480000	480000	480000	336000	336000	336000	336000	336000	336000	336000	336000	336000	1226000
PVF	0.91743	0.84168	0.77218	0.70843	0.64993	0.59627	0.54703	0.50187	0.46043	0.42241	0.38753	0.35553	0.32618	0.29925	0.27454
Present value of cash flows	440367	404006	370648	340044	311967	200346	183804	168627	154704	141930	130211	119460	109596	100547	336584

Present value of cash inflow	3512840
Present value of cash outflow	3600000
Net Present value	-87160

Conclusion: KKI should not proceed with the investment since it is giving negative NPA.

Case b.

Revised Assumptions
No. of years facility will last for	13 Years
Revised Operating cost	$300,000
Cost involved in Manufacturing Kite Facility	$1,200,000
Cost involved in Manufacturing Board Facility	$1,400,000

	Years
	1	2	3	4	5	6	7	8	9	10	11	12	13
Profit before CCA & Tax	450000	450000	450000	450000	450000	450000	450000	450000	450000	450000	450000	450000	450000
Less: CCA on land	110000	110000	110000	110000	110000	0	0	0	0	0	0	0	0
CCA on Kite facility	240000	240000	240000	240000	240000	0	0	0	0	0	0	0	0
CCA on Board Facility	280000	280000	280000	280000	280000	0	0	0	0	0	0	0	0
Profit before TAX	-180000	-180000	-180000	-180000	-180000	450000	450000	450000	450000	450000	450000	450000	450000
Less:TAX	0	0	0	0	0	135000	135000	135000	135000	135000	135000	135000	135000
Profit after tax	-180000	-180000	-180000	-180000	-180000	315000	315000	315000	315000	315000	315000	315000	315000
Cash inflow	450000	450000	450000	450000	450000	315000	315000	315000	315000	315000	315000	315000	315000
Salvage value (after tax)
Kite facility													160000
Board facility													180000
Land													550000
Net cash flow	450000	450000	450000	450000	450000	315000	315000	315000	315000	315000	315000	315000	1205000
PVF	0.91743	0.84168	0.77218	0.70843	0.64993	0.59627	0.54703	0.50187	0.46043	0.42241	0.38753	0.35553	0.32618
Present value of cash flows	412844	378756	347483	318791	292469	187824	172316	158088	145035	133059	122073	111993	393045

Present value of cash inflow	3173777
Present value of cash outflow	3150000
Net Present value	23777

Conclusion: KKI should proceed with the revised assumptions since it is giving positive NPA