Question

The Lake Charles Chemicals LLC is considering investing in a new gas to liquids technology. R&D scientists and engineers are investigating a new liquid-based catalyst system that will enable to operate the reactor at lower temperature and pressure to achieve higher conversion efficiencies. The company expects a three-year R&D period before they start producing the product as a commercial commodity. The following financial information is presented for management review.

• R&D Cost: $6.5 million over a three-year period: $1 million at the beginning of year; $2.5 million at the beginning of year 2; and $3 million at the beginning of year 3. For tax purposes, these R&D expenditures will be expensed rather than amortized.

• Capital investment: $5 million at the beginning of year 4. This investment consists of $2 million in a building and $3 million in plant equipment. The company already owns a piece of land as the building site.

• Financing: The company also borrowed $2 million from a national bank at 25% interest at the beginning of year 4.

• Depreciation method: The building is depreciated based on straight line depreciation method and the plant equipment is depreciated based on double-declining balance method. • Project life: 10 years after a three-year R&D period. • Salvage value: 10% of the initial capital investment for the equipment and 50% for the building (at the end of the project life) • Total Sales: $50 million (at the end of year 4), with an annual sales growth rate of 10% per year (compound growth) during the next five years (year 5 through year 9) and - 10% (negative compound growth) per year for the remaining project life.

• Out-of-pocket expenditures: 80% of annual sales.

• Working Capital: $5 million is considered as an investment at the beginning of year 4 and fully recovered at the end of project life. • Marginal tax rate: 40%

a) Determine the net after-tax cash flows over the project life

b) Determine the IRR for this investment

c) Determine the equivalent annual worth for the investment at MARR = 20%

Answer 1

ANSWER

		Year	4	5	6	7	8	9	10	11	12	13
	A	Depreciation of Building($2million-$1million)/10	$100,000	$100,000	$100,000	$100,000	$100,000	$100,000	$100,000	$100,000	$100,000	$100,000
		Depreciation of Equipment :
	B	Book Value at beginning of Year	$3,000,000	$2,400,000	$1,920,000	$1,536,000	$1,228,800	$983,040	$786,432	$629,146	$503,316	$402,653
	C	Depreciation Rate =(1/10)*200%	20%	20%	20%	20%	20%	20%	20%	20%	20%	20%
	D=B*C	Annual Depreciation	$600,000	$480,000	$384,000	$307,200	$245,760	$196,608	$157,286	$125,829	$100,663	$80,531
	E=B-D	Book Value at End of Year	$2,400,000	$1,920,000	$1,536,000	$1,228,800	$983,040	$786,432	$629,146	$503,316	$402,653	$322,123
	F=A+D	Total Annual Depreciation Expenses(Building+equipment)	$700,000	$580,000	$484,000	$407,200	$345,760	$296,608	$257,286	$225,829	$200,663	$180,531
		Salvage Cash Flows:
	G	After Tax Salvage Value of Building	$1,000,000
	H	Before tax Salvage Value of Equipment=10%*$3million)	$300,000
	I	Book Value at end of year13	$322,123
	J=I-H	Loss on Salvage	$22,123
	K=J*40%	Tax Saving on Loss(40%*22123)	$8,849
	L=H+K	After Tax Salvage Cash Flow from Equipment	$308,849
	M=G+L	Total Salvage Cash Flow at end of year 13	$1,308,849

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