Liam Henby, a financial analyst working for Delta Company, has developed an excellent investment proposal that his boss, the VP of Finance, wishes him to analyze. The VP also wants Liam to recommend whether the company should proceed with the project. The VP will take this recommendation to the company's CEO. Liam has approached you to help him complete the task.
The project involves the production of components for the wireless communication business and requires a two-year development period. The project requires the immediate purchase of land costing $600,000. A specialized building will be constructed over the next year with payment of $1.1 million due in exactly one year. Testing will begin at this point, and after a year the machinery required to produce the components will be purchased at a cost of $175,000. Payment is due at the end of the second year.
Sales will begin in the third year and, as is usual, sales and expenses will be deemed to be received at the end of each year. For each year of the 10-year life of the project, sales are expected to be $900,000 while operating expenses will be $325,000. These are the averages of the estimates obtained from the marketing staff and the production department. In addition, to support the increased sales, the firm will have to invest $250,000 in current assets, while payables and accruals are expected to increase by a total of $80,000.
After ten years of sales, the project will be terminated. Proceeds from the sales of the building are expected to be $500,000, but Delta Company will be required to spend $200,000 to complete an environmental cleanup. In addition, it will cost $75,000 to have the building moved off the site. The machinery will have a scrap value of $50,000. The land on which the building sat is expected to appreciate in value at an average rate of 9% per year. The CCA rate on the building is 4% and is 30% on the machinery. Delta Company's cost of capital is 15% and the company's tax rate is 40%. Note that only one-half of capital gains are taxable.
Analyze this project for Liam Henby and develop the recommendation that Liam should present to the VP of Finance. Be sure to provide a complete rationale for your recommendation.
The following format should be used for a summary of your solution:
NPV of Project:
- Incremental Cost (now)
- Incremental Cost (building)
- Incremental Cost (machinery)
+ PV of incremental after-tax operating income
+ PV of tax shield from incremental CCA on building
+ PV of tax shield from incremental CCA on machinery
+ PV of Salvage on building
+ PV of Salvage on machinery
- PV of tax shield lost due to salvage on building
- PV of tax shield lost due to salvage on machinery
- Additional working capital required
+ PV of working capital recovered
+ PV of after-tax value of land