Bender Guitar Corporation, a manufacturer of custom electric guitars, is contemp

Question

Bender Guitar Corporation, a manufacturer of custom electric guitars, is contemplating a $1,000,000 investment in a new production facility. The economic life of the facility is estimated to be five years, after which the facility will be obsolete and have no salvage value.

To make the new facility operational, building improvements costing $400,000 will be required. In addition, a $50,000 increase in working capital will be needed.

Bender's accounting and marketing departments have provided the following information: the firm will use the straight-line method of depreciation; the Company is in the 30% tax bracket; the weighted average cost of capital is 8%.

Here are Earnings before Interest and Taxes (EBIT) estimates for the new facility:

Year 1.........$80,000

Year 2.......$100,000

Year 3.......$120,000

Year 4........$140,000

Year 5.......$165,000

Answer the following questions:

1. Diagram the cash flows for the project using a time line. For each of Years 1 through 5, include the following data on your diagram (in this order) : EBIT, tax, depreciation, Operating Cash Flow (OCF), and discounted OCF.

2. Indicate the initial investment cost, the present value, the Net Present Value (NPV), and the payback (measured in years based on non-discounted OCF numbers).

3. Evaluate the project's efficacy. Is this facility worthwhile, based upon your calculations ? Why or why not ? What does the NPV decision rule indicate for this project ? If you were Bender's financial manager, what other factors would you consider before deciding whether or not to recommend construction of the production facility ?

Explanation / Answer

1 EBIT tax EAT Depreciation Operating cash flow PVIF DCF Year 1 80000 24000 56000 280000 336000 0.925926 311111.1 Year 2 100000 30000 70000 280000 350000 0.857339 300068.6 Year 3 120000 36000 84000 280000 364000 0.793832 288954.9 Year 4 140000 42000 98000 280000 378000 0.73503 277841.3 Year 5 165000 49500 115500 280000 445500 0.680583 303199.8 PV 1481176 2 Initial investment 1450000 less PV of DCF 1481176 NPV 31176 Payback period OCF CCF 0 336000 336000 1 1 350000 686000 1 2 364000 1050000 1 3 378000 1428000 1 4 445500 22000 0.049382716 5 4.05 years 3 The NPV indicates that the project is acceptable as the NPV is positive. The factors to be considered are the inflation, the future tax rate, fluctuation in foreign exchange rate if goods are imported or exported and any other investment opportunity available to compare it with the present investment opportunity. Please rate

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