Knack Inc. (Knack) is considering expanding its operations by adding a new product line. This project would
Question:
Knack Inc. (Knack) is considering expanding its operations by adding a new product line. This project would have a 10-year time horizon, after which the product line would be discontinued. The project would require new production equipment costing $6.5 million. This production equipment would have a useful life of 10 years and NO salvage value. The capital cost allowance (CCA) rate on the equipment would be 20% and is eligible for the accelerated investment incentive rules (ACII) for capital cost allowance (CCA).
A building would need to be constructed at a cost of $15 million. The building would have a $3 million salvage value at the end of its useful life of 45 years. At the end of the project, the building would have a salvage value of $9 million. The capital cost allowance (CCA) rate for the building would be 3% and is eligible for the accelerated investment incentive rules (ACII) for CCA. The building would be constructed on a vacant piece of land that Knack purchased several years ago for $3 million. The land has a current market value of $4.5 million and is expected to have a market value of $7.9 million at the end of the project. Changes in net working capital investments are forecast as follows: • Inventory: Increase in average balance of $2 million
• Accounts receivable: Increase in average balance of $1.5 million
• Accounts payable: Increase in average balance of $800,000
Sales are expected to be $24 million each year of the project.
Knack’s cost of goods sold is estimated to be 60% of sales, operating expenses (excluding depreciation) are estimated to be 5% of sales, and depreciation is estimated to be 3% of sales each year.
In addition, Knack incurred $1.2 million of expenses for a marketing study specifically to determine whether the new product would appeal to potential customers. The marketing study showed an overwhelmingly positive response from customers. Knack’s WACC is 7% and its effective tax rate is 37%.
Provide a net present value analysis of Knack’s project, recommend whether Knack should accept or reject the project and provide the reason for your recommendation.
Supply Chain Management Strategy Planning and Operation
ISBN: 978-0133800203
6th edition
Authors: Sunil Chopra, Peter Meindl