Benson Enterprises is evaluating alternative uses for a three-story manufacturing and warehousing building just purchased for $ 120,000. The company can rent the building for $ 70,000 per year for 15 years. Alternatively the company could modify the existing structure to use for its own manufacturing and warehousing needs. Bensons production engineer feel the building could be adapted to handle one of two new product lines. The cost and revenue data for the two products alternatives are as follows:

Product A Product B Initial cash Outlays for Building Modifications 36,000 54,000 Initial cash Outlays for Equipment 144,000 162,000 Annual Pre-tax cash revenues (growing at sam e rate as Demand) 300,000 250,000 Annual Pre tax Expenditures (growing at sam e rate as Demand) 60,000 50,000 Real Demand Growth 3% 2% Cost of Building Restoring 20,000 25,000

The building will be used for only 15 years (note: same as likely tenant agreement) for either product A or product B. After 15 years, the building will be too small for efficient production of either product line, and then Benson plans to rent the building. To rent the building again, Benson will need to restore the building to its present layout. The estimated cash flows (costs) of restoring the building if Product A has been undertake is $ 20,000, assumed to occur at the end of year 15. If Product B has been manufactured, the cash cost to restore the building will be $ 25,000 instead, also this is assumed to occur at the end of year 15. These cash costs can de deducted from the taxable income, for tax purposes, in the year the expenditures occur. In case the renting option is chosen, there is no need to face any restoring expenses of course. In addition, while evaluating investment opportunities the company has already faced an expense of $ 10,000 for fees to a consulting company in the past, and this are considered by the management as sunk costs. Benson will depreciate the original building and the equipment (purchased for $ 120,000) over 15 year life to zero, regardless of which project it chooses. The building modifications and equipment purchases for either product are estimated to have a 15 years life (hence residual value is zero). They will depreciate by straight line method. The firms tax rate is 34%. Product A is in the same line of business, and the company has = 1.4, while Product B is in a new line of business and the industry beta is then equal to = 0.7. Assume the = 1 for real estate business. Assume also an equity (market) premium equal to 8% and a risk free rate over the horizon of the project equal to 5%. For simplicity, assume all cash flows occur at the end of the year. The initial outlays for modifications and equipment will occur today (year zero) and the restoration outlays will occur at the end of the year 15. 1. Which use of the building would you recommend to management? Hint: there is an opportunity cost for not renting and this should be considered. However, this opportunity cost should be considered after taxes have been paid, hence it should be deducted from the net income. 2. Assume that investing in Product A would result into product cannibalization (Example: Diet Coke Vs. Coke Zero). That is, Product A would be very similar to an existing product already produced so that the revenue reduction for the existing project would be equal to $ 30,000 in the first year of Product A production and increases as the demand for Product A increases. How this would change your answer in point 1? Hint: side effects of a project represented by product cannibalization, should be deducted from the net income.