Araucana Fabricating manufactures springs and related components for a variety of industrial and consumer end products. AF is evaluating a new business opportunity. In response to the growing health consciousness of the affluent aging baby boomer generation, a new concept in traction-associated exercise equipment is being developed. AF feels confident it can be a supplier of choice of the high quality springs needed for this new generation of equipment. AF has determined that its existing manufacturing facilities are not suitable for the manufacture of the type of spring needed. Hence, in order to evaluate whether to enter this market, AF needs to consider the return on investment in a new manufacturing facility. AF has identified two options for its potential new manufacturing site:
Option A: Renovation of an existing warehouse (economic life of 10 years)
Option B: Construction of a completely new facility (economic life of 20 years)
AF projects it will be able to sell 9,000 spring sets per year for the foreseeable future. Price per spring set is $699 (in year end 1 dollars). AF has employed a nominal discount rate of 7 percent on similar construction projects in the past. AF’s combined state plus federal marginal tax rate is 35 percent. The following additional data have been collected. Assume all cash flows occur at the end of the year. Inflation is 3 percent per year. Depreciation expense is calculated on a straight-line basis, with no salvage value.
..................................Option A Option B
Construction costs* $3,200,000 $9,300,000
Annual operating costs**
Fixed .....................$1,000,000** $860,000**
Variable................. $530/spring set $530/spring set
*Assume all construction costs are incurred in period 0.
**Assume all these operating costs are incremental and represent cash flows with one exception, the straight-line depreciation of the construction costs which is included in fixed costs. These operating cost projections apply to the first year of operations. Cash costs (as well as revenues) are expected to increase with inflation.
Required: Prepare a financial analysis of the two options and make a recommendation. Use the income statement to net cash flow format, reflecting EBITDA, EBIT, EBIAT, and NCF.