Your firm is considering investing in a new line of business. The first stage which you are
Question:
Your firm is considering investing in a new line of business. The first stage which you are to evaluate involves a regional rollout to gain knowledge and test the waters.
All initial investments would be made in year 0 and the business would operate for five years (years 1-5). At the end of five years, this line of business will either shut down, or be expanded to additional locations. If you are able to expand, significant economies of scale will exist in the cost structure of this project. Here are the preliminary forecasts for implementing the regional rollout:
- You paid $5,000 to an outside market research firm to generate the following projections.
- Purchase cost for the necessary equipment $90,000 in year 0
- The cost of shipping and installation is $3,000
- Capital equipment would be depreciated using the MACRs 7-year schedule but would only be used for five-years
- The equipment will be located in an empty warehouse that your firm owns. It was purchased 5 years ago for $100,000, and could be leased out today for $8,000 per year.
- The equipment can be sold in year 6 for $10,000.
- There will be no impact on Accounts Payable or Accounts Receivable
- The only working capital needed would be $25,000 of inventory to get the project up and running. Thereafter, inventory needs would be approximately 5% of revenue.
- Revenue would be $200K in the first year and then grow at 5% per year. However, this growth rate is highly uncertain and could be as low as 1% or as high as 8.5%.
- Variable costs are expected to be 67% of revenue.
- Fixed SG&A costs would be $12K per year (in years 1-5)
- The marginal tax rate is 21%
- While this is a new line of business, if you go forward, you expect to take sales in part from your existing business. You believe that 10% of your sales for this project will come from existing business.
- Your firm's WACC is 10%.
- You believe this project is about 15% higher risk than your current operations.
Provide a complete evaluation of this project, including NPV, IRR, Payback and NPV Profile? Should you proceed with the project? Why or why not?
Fundamentals of Corporate Finance
ISBN: 978-1259024962
6th Canadian edition
Authors: Richard Brealey, Stewart Myers, Alan Marcus, Devashis Mitra, Elizabeth Maynes, William Lim