Bender Guitar Corporation, a manufacturer of custom electric guitars, is contemp
ID: 2706275 • Letter: B
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
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).
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?
Required Return 8% 1 2 3 4 5 Time Period Y0 Y1 Y2 Y3 Y4 Y5 PV (values at 8%) 0.9259 0.8573 0.7938 0.735 0.6806 Initial Investment ($1,000,000) Building Improvement Cost ($400,000) Additional Work Capital ($50,000) EBIT $80,000 $100,000 $120,000 $140,000 $165,000 Less Tax 30% ($24,000) ($30,000) ($36,000) ($42,000) ($49,500) PAT $56,000 $70,000 $84,000 $98,000 $115,500 Add Back Depreciation $200,000 $200,000 $200,000 $200,000 $200,000 Op Cfs ($1,450,000) $256,000 $270,000 $284,000 $298,000 $315,500 Discounted CFs $237,037 $231,481 $225,448 $219,039 $214,724 NPV $322,270.23Evaluate 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
The table with the values seem to be right till the PAT level.
However the annual depreciation should include the building improvement also, so annual depreciation = (1,000,000+400,000)/5 = 280,000
So the OCF table is as below:
NPV is the sum of all discounted cashflows less the initial investment of 1,450,000.
Cumulative cashflow till year 4 = 1,428,000
So payback = 4+(1,450,000-1,428,000)/445,500 = 4.049 years
As the NPV is positive, it is worthwhile proceeding on this project. However, we should also consider other factors, for example, the riskiness of the cashflows - any variance in the same will lead to a problem as the NPV is only marginally positive and we do not have enough buffer.
Hope this helped ! Let me know in case of any queries.
Year 1 Year 2 Year 3 Year 4 Year 5 EBIT 80,000 100,000 120,000 140,000 165,000 Less:tax 24,000 30,000 36,000 42,000 49,500 PAT 56,000 70,000 84,000 98,000 115,500 Add:depreciation 280,000 280,000 280,000 280,000 280,000 Add: working capital 50,000 OCF 336,000 350,000 364,000 378,000 445,500 Discounted CF 311,111 300,069 288,955 277,841 303,200 NPV 31,176Related Questions
drjack9650@gmail.com
Navigate
Integrity-first tutoring: explanations and feedback only — we do not complete graded work. Learn more.