Question

RWE Enterprises: Expansion Project Analysis RWE Enterprises, Inc. (RWE) is a small manufacturing firm located in the hills just outside of Nashville, TN. The firm is engaged in the manufacture and sale of feed supplements used by cattle raisers. The product has a molasses base but is supplemented with minerals and vitamins that are generally thought to be essential to the health and growth of beef cattle. The final product is put in 125-pound or 200-pound tubs that are then made available for the cattle to lick as desired. The material in the tub becomes very hard, which limits the animals’ consumption. The firm has been running a single production line for the past five years and is considering the addition of a new line. The addition would expand the firm’s capacity by almost 120% since the newer equipment requires a shorter down time between batches. After each production run the boiler used to prepare the molasses for the addition of minerals and vitamins must be heated to 180 degrees Fahrenheit and then must be cooled down before the next batch. The total production run entails about 4 hours and the cool down period is 2 hours (during which time the whole process come to a halt). Using two production lines increases the overall efficiency of the operation since workers from the line that is cooling down can be moved to the other line support the “caning” process involved in filling the feed tubs. The second production line equipment will cost $3 million to purchase and install and will have an estimated life of 10 years at which time it can be sold for an estimated after-tax scrap value of $200,000. Furthermore, at the end of five years the production line will have to be refurbished at an estimated cost of $2 million. RWE’s management estimates that the new production line will add $700,000 per year in after-tax cash flow to the firm such that the full 10-year cash flows for the line are as follows:

Year                                      After-tax Cash Flow

0                                              $(3,000,000)

1                                             700,000

2                                              700,000

3                                              700,000

4                                             700,000

5                                             (1,300,000)

6                                             700,000

7                                             700,000

8                                              700,000

9                                              700,000

10                                           900,000

A. If RWE uses a 10% discount rate to evaluate investments of this type, what is the net present value of the project? What does this NPV indicate about the potential value RWE might create by purchasing the new production line?

B. Calculate the internal rate of return and profitability index for the proposed investment. What do these two measures tell you about the project’s viability?

C. Calculate the payback and discounted payback for the proposed investment. Interpret your findings

Answer 1

Answer A:

Net present value of the project = $136,462.99

It indicates that the potential value add to shareholders RWE might create is $136,462.99. Since NPV is positive the expansion project is acceptable.

Workings:

Answer B:

Internal rate of return of the proposed investment = 11.05%

Profitability index (PI) for the proposed investment = 1.05

IRR at 11.05% is greater than cost of capital at 10% hence project is viable and acceptable.

PI at 1.05 which is greater than 1 and hence project is viable and acceptable.

Workings:

Please see table in answer A above.

Answer C:

Payback period of the proposed investment = 7.14 Years

Discounted payback for the proposed investment = 9.61 years

The company does not have any cut off for payback period and discounted payback period.

Payback period which gives how quickly the project recovers its investment is longer. But since no cut off is given it may be acceptable since NPV is positive and IRR is less than cost of capital.

Discounted payback period is almost nearer to the project life which is pretty long. But since no cut off is given it may be acceptable since NPV is positive and IRR is less than cost of capital.