Question

Smith Machining Corp. is a small business considering investing in one of 2 new product production lines. However, they can only afford to do one of the projects. The development and implementation of either project will take a year and the initial cash outlay will be $1,500,000 if they take a traditional bank loan at 10%. If they pursue a Small Business Association (SBA) guaranteed loan through their bank, the rate on the loan will be 7% however, they will need to pay an up-front fee of 10% of the net proceeds of their loan, which can be added to the loan. The projects have the following projected net cash flows:

Year	Project A	Project B
1	$         250,000	$         100,000
2	$         250,000	$         100,000
3	$         250,000	$         100,000
4	$         500,000	$         100,000
5	$         500,000	$         100,000
6	$         250,000	$         400,000
7	$         100,000	$         750,000
8	$            50,000	$         750,000
9	$            50,000	$      1,000,000

1. Calculate and show the NPV of each project at the 10% rate
2. Calculate and show the NPV of each project at the 7% SBA loan rate
3. Which project would you choose, A or B and why?
4. Does the SBA loan improve the result and would you recommend getting the SBA loan even with the added 10% cost? Why or why not?

Answer 1

a) NPV of project A (10%)

= -1500000+250000/1.1+250000/1.1^2+250000/1.1^3+500000/1.1^4+500000/1.1^5+250000/1.1^6+100000/1.1^7+50000/1.1^8+50000/1.1^9

=$10644.93

NPV of project B (10%)

= -1500000+100000/1.1+100000/1.1^2+100000/1.1^3+100000/1.1^4+100000/1.1^5+400000/1.1^6+750000/1.1^7+750000/1.1^8+1000000/1.1^9

=$263714.99

b) In SBA rate loan, total loan taken = $1500000 *1.1 = $1650000

NPV of project A (7%)

=-1650000+250000/1.07+250000/1.07^2+250000/1.07^3+500000/1.07^4+500000/1.07^5+250000/1.07^6+100000/1.07^7+50000/1.07^8+50000/1.07^9

=$29177.38

NPV of project B (7%)

= -1650000+100000/1.07+100000/1.07^2+100000/1.07^3+100000/1.07^4+100000/1.07^5+400000/1.07^6+750000/1.07^7+750000/1.07^8+1000000/1.07^9

=$474059.51

c) We would choose project B as the NPV is higher than project A in both cases.

d) The SBA loan increases the NPV and hence is recommended even with added 10% cost. This is because the lower discount rate more than compensates for the 10% extra fee,