5. An Edmonton firm is deciding whether to build a factory to produce Mayor Don

Question

5. An Edmonton firm is deciding whether to build a factory to produce Mayor Don Iveson action figures. It will then sell these figures in local retail outlets. The factory, if built, will not operate this year (year 0), but will start operating in year (1), and will operate for 20 years in total. Each year it operates, its revenues will be $1,000,000. In year the business's operating costs will be $1,500,000. In the year 2, the operating costs will be S1,100,000. In all subsequent years, operating costs will be $500,000 per year The cost of the factory is $4,200,000. After the factory has operated for 20 years, it will be obsolete but its parts will be worth $400,000. The business is able to borrow or lend money at a market interest rate of R. Finally, suppose the firm is certain about all of the numbers given in the question. (a) If the interest rate is 6%, should the firm make the investment? (b) If the interest rate is 9% should the firm make the investment?

Explanation / Answer

Working notes:

(1) Net benefit (NB) = Revenue - Cost

(2) NB, year 0 = First cost

(3) NB, year 20 = Revenue + Salvage value - Cost = Revenue + 400,000 - Cost

(a) Present Worth (PW) at 6% Interest rate is computed below.

Since PW > 0, Firm should make the investment.

(b) Present Worth (PW) at 9% Interest rate is computed below.

Since PW < 0, Firm should not make the investment.

Year Revenue ($) Cost ($) NB ($) PV Factor @6% Discounted NB ($) (A) (B) (C)=(A)-(B) (D) (C)x(D) 0 42,00,000 -42,00,000 1.0000 -42,00,000 1 10,00,000 15,00,000 -5,00,000 0.9434 -4,71,698 2 10,00,000 11,00,000 -1,00,000 0.8900 -89,000 3 10,00,000 5,00,000 5,00,000 0.8396 4,19,810 4 10,00,000 5,00,000 5,00,000 0.7921 3,96,047 5 10,00,000 5,00,000 5,00,000 0.7473 3,73,629 6 10,00,000 5,00,000 5,00,000 0.7050 3,52,480 7 10,00,000 5,00,000 5,00,000 0.6651 3,32,529 8 10,00,000 5,00,000 5,00,000 0.6274 3,13,706 9 10,00,000 5,00,000 5,00,000 0.5919 2,95,949 10 10,00,000 5,00,000 5,00,000 0.5584 2,79,197 11 10,00,000 5,00,000 5,00,000 0.5268 2,63,394 12 10,00,000 5,00,000 5,00,000 0.4970 2,48,485 13 10,00,000 5,00,000 5,00,000 0.4688 2,34,420 14 10,00,000 5,00,000 5,00,000 0.4423 2,21,150 15 10,00,000 5,00,000 5,00,000 0.4173 2,08,633 16 10,00,000 5,00,000 5,00,000 0.3936 1,96,823 17 10,00,000 5,00,000 5,00,000 0.3714 1,85,682 18 10,00,000 5,00,000 5,00,000 0.3503 1,75,172 19 10,00,000 5,00,000 5,00,000 0.3305 1,65,257 20 14,00,000 5,00,000 9,00,000 0.3118 2,80,624 PW ($) = 1,82,288

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