Question

Case 11.1 The Jam Music Company

The Jam Music Company is considering expanding its production line to satisfy the demand for more CDs. The company has commissioned consultant studies for the expansion, spending $200,000 for these studies. The results of the studies indicate that the firm must spend $900,000 on a new building and $300,000 on production equipment if it wants to have state-of-the-art production. The consultants’ report predicts that the company can increase its revenues by $400,000 each year while incurring an increase of $160,000 in expenses. The consultants expect rivals to step up production within 5 years, reducing benefits from the expansion to Jam after 5 years. Therefore, a 5-year time horizon is assumed for this expansion project. The expansion would require that the company increase its current assets by $100,000 initially, but these asset accounts will be returned to previous levels at the end of the project.

Assume that the building is depreciated as a 10-year MACRS asset and that it can be sold at the end of 5 years for $800,000. Further assume that the equipment is depreciated using MACRS over a 5-year period and that it can be sold at the end of 5 years for $150,000. The marginal tax rate of Jam is 40 percent, and the cost of capital for this project is 10 percent.

Requirements

A. Should Jam invest in this project? Explain.

B. What is the internal rate of return on this project?

C. If the increase in revenues is only $350,000 per year, should Jam invest in this project? Explain your answer.

D. If the revenues start at $600,000 for the first year and decline each year by 25 percent, but expenses do not change, should Jam invest in this project? Explain why or why not.

Answer 1

Answer A:

Yes, Jam should invest in this project. The project is acceptable since its NPV is positive at = $11,630.48

Workings:

Answer B:

Internal rate of return on this project = 10.27%

Workings is as above as given in answer to question A.

Answer C:

Base NPV = $11,630.48

If increase in revenue is $350,000:

Reduction in NPV = (400000 - 350000) * (1 - 40%) * ((1 - 1/ (1 + 10%) ⁵) / 10%) = $113,723.60

Hence:

If increase in revenue is $350,000, NPV = $11,630.48 - 113,723.60 = - $102,093.13

NPV becomes negative.

If the increase in revenues is only $350,000 per year, Jam should not invest in this project.

Answer D:

If the revenues start at $600,000 for the first year and decline each year by 25 percent, but expenses do not change,

NPV = - $21,144.39

NPV is negative; hence Jam should not invest in the project.

Jam should not invest in this project.

Workings: