ZeeBancorp is planning the establishment of a contract collection service subsidiary that would provide collection services to small and medium-size companies. Compensation would be in the form of a percentage of the amount collected. For amounts collected up to $100, the fee is 55 percent of the amount collected. For amounts collected between $100 and $500, the fee would be 40% of the total amount collected on the account. For amounts collected over $500, ZeeBancorp would receive 35% of the total amount collected on the account. ZeeBancorp expects to generate the following amount of business during the fi rst year of operation of the new subsidiary:
Act Class #of collections average amount collected for each account up to 100 4800 75 between 100 and 500 2100 325 over 500 1250 850
Over the projected 10-year life of this collection venture, the number of accounts in each group is expected to grow at 6 percent per annum. Th e average amount collected from each account is expected to remain constant.
To establish the collection subsidiary, ZeeBancorp will have to rent office space at a cost of $250,000 for the first year. (Assume the rent is payable at the end of each year.) Th is amount is expected to grow at a rate of 11 percent per year. Other operating expenses (excluding depreciation) are expected to total $350,000 during the first year and grow at an 11 percent annual rate.
ZeeBancorp will have to invest $150,000 in net working capital if it undertakes this venture.
In addition, required new equipment will cost $275,000 to purchase and an additional $25,000 to install. Th is equipment will be depreciated using the MACRS schedule for a 7-year asset. Th e salvage value for the equipment is estimated to be $50,000 at the end of 10 years. Th e firm’s marginal tax rate is estimated to be 40 percent over the project’s life, and its average tax rate is projected to be 35 percent over the project’s life. Th e fi rm requires a 15 percent rate of return on projects of average risk.
1. Calculate the net investment required to establish the collection subsidiary.
2. Calculate the annual net cash flows over the 10-year life of the project.