Sanders Enterprises, Inc., has been considering the purchase of a new manufactur

Question

Sanders Enterprises, Inc., has been considering the purchase of a new manufacturing facility for $270,000. The facility is to be fully depreciated on a straight-line basis over seven years. It is expected to have no resale value after the seven years. Operating revenues from the facility are expected to be $105,000, in nominal terms, at the end of the first year. The revenues are expected to increase at the inflation rate of 5 percent. Production costs at the end of the first year will be $30,000, in nominal terms, and they are expected to increase at 6 percent per year. The real discount rate is 8 percent. The corporate tax rate is 34 percent. Sanders has other ongoing profitable operations.

Sanders Enterprises, Inc., has been considering the purchase of a new manufacturing facility for $270,000. The facility is to be fully depreciated on a straight-line basis over seven years. It is expected to have no resale value after the seven years. Operating revenues from the facility are expected to be $105,000, in nominal terms, at the end of the first year. The revenues are expected to increase at the inflation rate of 5 percent. Production costs at the end of the first year will be $30,000, in nominal terms, and they are expected to increase at 6 percent per year. The real discount rate is 8 percent. The corporate tax rate is 34 percent. Sanders has other ongoing profitable operations.

Explanation / Answer

Time line 0 1 2 3 4 5 6 7 Equipment cost -270000 =Initial Investment outlay -270000 Operating revenue In nominal terms 105000 110250 115762.5 121550.6 127628.2 134009.6 140710 -production cost In nominal terms 30000 31800 33708 35730.48 37874.31 40146.77 42555.57 -Depreciation (cost of equipment and plant)/7 -38571.4 -38571.4 -38571.4 -38571.4 -38571.4 -38571.4 -38571.4 = 96428.57 103478.6 110899.1 118709.7 126931 135584.9 144694.2 -taxes =(Operating income - fixed cost - depreciation)*(1-tax) 63642.86 68295.86 73193.39 78348.39 83774.48 89486.04 95498.16 +Depreciation 38571.4 38571.4 38571.4 38571.4 38571.4 38571.4 38571.4 =after tax operating cash flow 102214.3 106867.3 111764.8 116919.8 122345.9 128057.4 134069.6 Total Cash flow -270000 102214.3 106867.3 111764.8 116919.8 122345.9 128057.4 134069.6 real rate= 8% Nominal rate= =(1+real rate)*(1 + inflation)-1 0.134 Discount factor= =(1+ nominal rate)^n 1 1.134 1.285956 1.458274 1.653683 1.875276 2.126563 2.411523 PV of discounted cash flow = Total cash flow/Discount factor -270000 90136.03 83103.35 76641.82 70702.67 65241.52 60218.02 55595.39 NPV = Sum of discounted cash flows= 231638.8 Accept project as NPV > 0

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