Focus Drilling Supplies has been growing steadily over the last 20 years. With increased exploration in the mining sector, the company has decided to expand their facilities for supplies and custom drill bit production to meet the increased demand.
The expansion will occur over 4 years and is expected to require $2.8 million.
Management has developed a payment plan for carrying out this expansion. The plan requires a cash input of $300,000 now, $700, 000 one year from now, $800,000 two years from now, and finally, $1,000,000 four years from now.
While Focus Drilling is able to allocate $2.6 million dollars from the cash reserves to fund the project, there is no other contingency fund for cost overruns or construction delays. However, any interest earned on the expansion fund during the four-year time frame will be set aside for the project.
Before the final decision on implementation, the company treasurer is asked to assess the plan to determine if the current $2.6 million allocation will meet the $2.8 million in payment obligations of the plan over the four-year period. The Treasurer has predicted interest rates over the next four years to be as follows:
- Year 1: interest rate of 4.5% p.a. compounded semi-annually
- Year 2: interest rate of 5.0% p.a. compounded semi-annually
- Year 3: interest rate of 5.0% p.a. compounded semi-annually
- Year 4: interest rate of 5.5% p.a. compounded semi-annually
As an alternative, the Treasurer has found that the $2.6 million cash allocation could be invested at a fixed rate of 5.2% p.a. compounded quarterly for a period of five years.
The company can withdraw part of the money from either investment at any time without penalty, to meet the cash payment requirements.
- Can Focus Drilling meet the cash payment requirements of the expansion given the variable interest rates given above? Use today as a focal date. Show your calculations.
- What, if any, is the accumulated value of the difference between the allocated cash available and the total cash payments required for the expansion?
- Can Focus Drilling meet the cash payment requirement by investing with the fixed five-year interest rate given above? Show your calculations.
- What, if any, is the accumulated value of the difference between the allocated cash available and the total cash payments required for the expansion?
- Which investment strategy should the company select and why?
Since the Treasurer's investment plan has a guaranteed rate for five years, suppose the company decided to delay the expansion for twelve months to take advantage of this fact. The payment plan to fund the expansion would retain the same payment schedule. However, the final payment in the last year would increase by 10%, due to projected increase in construction costs.
- What is the equivalent value, twelve months from now, of the cash available to fund the expansion? Show your calculations.
- Twelve months from now, what is the total of the value of the required cash payments? Show your calculations.
- Twelve months from now, what is the difference between the value of the funds available from (6), and the total present value of the required payments determined in (7)? Show your calculations.
- What is the accumulated value of this difference at the end of the expansion period? Show your calculations.
- In your opinion, should the proposed expansion be delayed or not? Explain your choice, giving advantages and risks.