Capital Budgeting – Example 1
General Farm Supply is considering the feasibility of expanding their line of fertilizers. They evaluate such projects by determining the net present value and internal rate of return.
General recently completed a feasibility study that indicated they would be able to sell as much fertilizer as they can produce. The study was performed by Fertilizer Consultants, Inc. at a cost of $100,000.
General has also determined facility needs that will accompany the expansion. Warehouse expansion will cost $500,000 and will be depreciated using the 5-year MACRS depreciation schedule. (.20, .32, .192, .1152, .1152, .0576). Equipment installation costs will total $50,000. General currently owns land next to their existing facility that can be used for the expansion. The land was purchased 10 years ago for $5,000. Current market value for the land is $20,000.
In order to finance the expansion, General plans to issue $500,000 in bonds. The bonds will have a 10% coupon rate and will mature in 10 years. They will have to pay $50,000 per year in interest on the bonds.
General uses a corporate-wide hurdle rate of 10.1% when evaluating capital projects. Their marginal tax rate is 35%.
General has determined that the expansion will allow them to sell 1,000,000 pounds of fertilizer per year at an estimated price of $0.30 per pound. Fixed costs per year are forecast at $40,000. Variable costs of $0.10 per pound are forecast.
General forecasts the following one-time changes in working capital in year 0:
Inventory will increase $20,000
Accounts receivable will increase $10,000
Accounts payable will increase $8,000
Any increase in NWC should be recaptured at the end of year 7.
Due to anticipated technological changes in the fertilizer industry, General is forecasting zero cash flow from this project beyond year 7.
General forecasts that the equipment that was purchased for this project can be sold for $40,000 at the end of year 7.
Help General’s CFO evaluate the project by completing the following on the Excel spreadsheet provided:
Find annual cash flows for years 0 through 7
Find the net present value
Find the internal rate of return
Should General do the project? Why or why not?