Question

Puffy Clouds, a maker of data storage products, is considering adding a new manufacturing facility. The new facility would be housed in an unused building that the firm bought 8 years ago for $5 million; the building is being depreciated over a 20 life to a salvage value of zero. The building can be sold today for $2 million, and the market value of the building is expected to increase at 5% per year going forward. The new facility would require the purchase of $50 million of equipment that would be depreciated straight line to zero over a useful life of 5 years. However, the firm expects this equipment would have a scrap value of $250,000 at the end of its 5-year life. The firm would finance the equipment purchase with a five-year debt issue that would carry an interest rate of 5% p.a. The new facility would add $20 million to annual revenues, which are currently $100 million per year. The higher manufacturing efficiency of the new facility would reduce annual operating costs from 40% of revenues to 35% for both existing and new sales revenues. The new facility would require a $500,000 increase in net working capital, which would be recovered at the end of the project. The firm’s tax rate is 20% and the required rate of return is 8%. Calculate the NPV and IRR for the new facility (25 points)

five year life

Answer 1

The $5 million cost of the land 8 years ago is a sunk cost and irrelevant. The $2 million sale price of the land today is an opportunity cost and is relevant. The sale price of the land in 5 years is a relevant cash flow as well. The fact that the company is keeping the land rather than selling it is unimportant. The land is an opportunity cost in 5 years and is a relevant cash flow for this project.

The debt payments (finance expenses) should not be considered separately because the required rate of return incorporates the cost of debt already.

Operating cash flow (OCF) each year = income after tax + depreciation

profit on sale of equipment at end of year 5 = sale price - book value

book value is zero as the equipment is fully depreciated.

after-tax salvage value = salvage value - tax on profit on sale of equipment

NPV and IRR are calculated using NPV and IRR functions in Excel

NPV is $15,194,084

IRR is 18.17%