You are leading a team from the finance group that is evaluating a manufacturing expansion proposal. It

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Question:

You are leading a team from the finance group that is evaluating a manufacturing expansion proposal. It is November of 2021, so you plan to analyze annual cash flows as of December of each year, beginning this year (2021). The goal for the expansion is to increase sales by $75 million when it becomes operational in 2024, and this capacity is expected to continue to grow at 8% each year for the 20 year useful life of the new facility. Historically your variable cost ratio has been 30% and you expect this to continue. Fixed costs at the new facility are expected to be $30 million initially, and to grow at a 6% rate over time. These expenses are historical averages and your company's practice is to use these to form the base case analysis of expansions like this. However, the variable cost ratio has varied between 25% and 45% in the past few years, while growth in fixed cost growth has varied between 5% and 9%. You plan to use these variations for your scenario analysis. Currently, your WACC is 11%. Your marginal tax rate is 25% (federal and state combined) and you expect this to remain constant for planning purposes. For scenario analysis, you plan to evaluate the base case using a 45% tax rate as a separate worst case scenario. For Projects of this size, your practice is to calculate the NPV, IRR, MIRR and Profitability Index.

Investment

The project will require several long term asset investments, as well as investment in Net Working Capital. There will be an investment in land, building, and two different types of equipment, which you have taken to calling Crushers and Grinders. Details and timing are below.

Land

The project will require an investment in land of $50 million. The land will be purchased in 2021. You have estimated that at the end of the project's life, you will be able to sell the land for $130 million. Building The building will be built for $130 million in 2022, with additional prep work required of $20 million in 2023. Once operational, the building will be depreciated using the MACRS 39 year straight line method. For analysis purposes, you ignore any half year or half month convention, and simply use 39 years. At the end of the project's life, you expect to be able to sell the building for $60 million.

Crushers The selected equipment has a 10 year useful life. It will be purchased in 2022 for $10 million. Installation costs of $3 million will be incurred in 2023. This pattern will be repeated in years 9 and 10 of operations in preparation for the replacement of the equipment so that we cover the project's 20 year operating life. This equipment qualifies as a 7 year asset for MACRS purposes and you expect this part of the tax laws to remain constant. Salvage values for the Crushers are expected to be $2 million each time. However, you expect the purchase price of the Crushers to increase a total of 25% when you repurchase them, with installation costs remaining constant.

Grinders The selected equipment has a 20 year useful life. It qualifies as a 10 year asset under MACRS rules. It will be purchased in 2023 with a purchase price of $20 million and installation of $5 million. Its salvage value is expected to be $3 million. NWC Net Working Capital, primarily in the form of inventory buildup, is expected to be maintained at 10% of next year's sales. So, timing wise, the first investment in NWC will be at the end of 2023 (operations begin in 2024), and then will increase each year based on the increase in Sales for the next year. It is expected that this NWC investment will all be returned at the end of the project's life.