Q1: When preparing capital budgeting analysis for a new project, Chris Johnson, a chief financial officer at BT Industries, faced a dilemma. The project involved a production of new type of shipping containers, which were significantly more durable and had a considerably longer useful life compared to conventional containers used in the industry. The year was 2009, and the equipment necessary for producing the containers was being sold for $900K. Each year, this cost is expected to increase by 20%. The useful life of the equipment and the project is 5 years. Mr. Johnson estimated that during a good year, the project will generate net cash flows of $700K per year, while during a bad year, the project will lose money, with an expected net cash flow of $-300K per year.
Because the economy suffered a significant decline just a year prior, there was uncertainty about the economy in general, and, very much affected by the economy, the demand for shipping and containers. Market analysts predicted that uncertainty will remain in 2010 and at this point, in 2009, the likelihood of 2010 being a good year is estimated at 40% and the likelihood of 2010 being a bad year is estimated at 60%. However, all uncertainty will get resolved in 2011. The likelihood of 2011 and all subsequent years being good years (recovery) is 60%, and the likelihood of these subsequent years being bad years (recession) is 40%.
Since he has not dealt with uncertainty regarding the future state of the economy before, Mr. Johnson is bewildered and asks your help in determining the course of action regarding this opportunity. Mr. Johnson has estimated that the WACC for the company in certain times has been 10%. Assume that the project has no tax implications, i.e. the tax rate of 0%.
- a)What is the NPV of investing into the machine in 2009? __________________
- b)What is the NPV (in year 2009) of delaying the investment until 2010? __________________
- c)Should the firm invest in the project in 2009, 2010, or not invest at all? __________________
- d)Assume that the firm has the possibility to invest in 2009 only. What is the value of knowing in 2009 with certainty the state of the world in 2010, with regards to this project? In other words, what is the maximum amount of money the company would pay to know in 2009 whether 2010 would be a good or a bad year? Explain your answer.
- Q2: As a financial manager of a company that produces and sells window glass, you have been recently asked to analyze alternatives to replacing an old furnace. In the glass-making process, before glass is formed, the glass batch – a mix of glass ingredients, which include silicon dioxide, sodium oxide, calcium oxide, and other additives – is melted at high temperature. The process can be both energy and time consuming, depending on the furnace and the volume of production.
The furnace the company currently uses has been installed 4 years ago at the cost of $1M, and nears the end of its useful life in December this year. After December, it can no longer be operated, because there is no possibility to refurbish it and in any way prolong its useful life. The annual depreciation on the old furnace was $200,000 per year, so at the end of its life it will have book value of $200,000. Unfortunately, there are no buyers for the old furnace and the company has to scrap it.
The old furnace has been rather inefficient, however. The annual energy cost associated with the furnace has averaged $250,000 per year, and it required six employees to operate it at the annual cost of $50,000 per employee. In addition, the inefficient design of the old furnace required time to heat the glass batch up. The chief operating officer estimated that the inefficiency resulted in productivity loss equivalent to one week worth of delays per year.
As regards new furnaces, the company has two alternatives. The first alternative is an electric furnace that costs $600,000 to buy and install. It has a useful life of 3 years. However, due to the relatively high costs of electricity, annual operating costs are estimated to be $200,000 per year in electricity and $20,000 per year in operator salaries. You determined that it is possible to use the accelerated depreciation schedule for the electric furnace and depreciate it straight-line over five years to the salvage value of zero. In fact, at the end of its useful life, you expect the electric furnace to have no value.
The second alternative is a gas furnace that costs $900,000 to buy and install. It has a useful life of 5 years. Because natural gas is relatively cheap, annual operating costs are estimated to be $100,000 per year in electricity but, due to the relative complexity of the machine, two operators will be needed at the total cost of $30,000 per year for the two. You determined that the company can depreciate the electric furnace straight-line to the salvage value of zero. Even though it will have the book value of $0 at that time, at the end of its useful life, the gas furnace can be sold for $100,000. In addition to these costs, the gas furnace will require an increase in inventories of 150,000 to hold a supply of liquid gas tanks during the operation of the machine. These inventories will be recovered at the end of the useful life of the machine.
Both of these furnaces reduce a week’s worth of delays in production process. For the past year, total sales for the company are predicted to reach $10,000,000, costs of goods are predicted at $7,000,000, and days of sales in inventories are 35 days (using 350 days as the number of working days per year).
The company faces a corporate tax rate of 35%, and you estimated that the discount rate which should be used for this project is 10% per year.
What should the company do?