Expansion Project Analysis

BQC’s marketing department estimates sales of 20,000 units annually if units sell for a price of $2000 each, therefore annual sales are estimated at $40 million.

Additional manufacturing capacity is needed which BQC can acquire by purchasing an existing building at a cost of $12 million. The building will be bought and paid for on December 31, 2009. The necessary equipment needed for manufacturing will be installed in late 2009 and paid for at the same time as the building. Including transportation and installation, the cost of the equipment is $8 million. An additional $6 million investment in net working capital is needed and will be made on December 31, 2009.

The project has an estimated economic life of 4 years. At the end of this time, the building is expected to have a market value of $7.5 million and a book value of $10.908 million. The equipment would have a market value of $2 million and a book value of $1.36 million.

The production department has estimated that variable manufacturing costs would total 60% of sales and that fixed overhead costs (excluding depreciation) would be $5 million a year.

In accordance with the Modified Accelerated Cost Recovery System (MACRS), depreciation expenses on the building would be $156,000 in 2010 and $312,000 in each of the years 2011, 2012, and 2013. For the equipment, depreciation expense is $1,600,000 in 2010, $2,560,000 in 2011, $1,520,000 in 2012, and $960,000 in 2013.

BQC’s marginal federal-plus-state tax rate is 40%; its cost of capital is 12%. For capital budgeting purposes, the company’s policy is to assume that operating cash flows occur at the end of the year. Because the plant would begin operations on January 1, 2010, the first operating cash flows would occur on December 31, 2010. BQC believes this project has the same amount of risk as an average project.

Replacement Project Analysis

BQC is considering replacing an old machine with a new, more sophisticated model for a project. The new machine’s purchase price is $380,000 and an additional $20,000 will be required to install it. It will be depreciated under MACRS yielding depreciation expenses of $80,000, $128,000, $76,000, $48,000, $48,000 in years 1 through 5, respectively, leaving a salvage value of $20,000 at the end of year 5. The old machine was purchased at a cost of $240,000 three years ago and has a current book value of $69,600. Its remaining depreciation expenses under MACRS are $28,800 in year 1, $28,800 in year 2, and $12,000 in year 3 at which point it will have a book value of $0 but 2 years of useful life remaining. The firm has found a buyer willing to pay $280,000 for the present machine and remove it at the buyer’s own expense. BQC expects that a $35,000 increase in current assets and an $18,000 increase in current liabilities will accompany the replacement.

Net operating cash flows (before tax) for the new machine are expected to be $220,000 per year for the 5 years of its useful life. With the present machine, net operating cash flows of $210,000, $190,000, $170,000, $150,000 and $130,000 are expected over the next five years respectively.

BQC estimates the liquidation value of the new machine at the end of its five-year useful life to be $50,000 after cleanup and removal costs. The old machine will be obsolete at the end of another 5 years and hence will have no salvage value. The $17,000 net working capital investment will be recovered at termination of the project.

BQC’s federal-plus-state tax rate remains at 40% and the replacement project is of slightly below-average risk. Because of the lower risk, the project’s cost of capital is only 11.5%.