Calculating impairment. On January 1, 2008, assume that Levi Strauss opened a new textile plant to produce synthetic fabrics. The plant is on leased land; 20 years remain on the nonrenewable lease.
The cost of the plant was $20 million. Net cash flow to be derived from the project is estimated to be $3,000,000 per year. The company does not normally invest in such projects unless the anticipated yield is at least 120%.
On December 31, 2008, the company calculates that cash flows from the plant were $2,800,000 for 2008. On the same day, farm experts predict cotton production will be unusually low for the next two years. Levi Strauss estimates the resulting increase in demand for synthetic fabrics will boost cash flows to $3,500,000 for each of the next two years. Subsequent years’ estimates remain unchanged at $300,000 per year. Ignore tax considerations.
a. Calculate the present value of the future expected cash flows from the plant when it opened.
b. What is the present value of the plant on January 1, 2009, immediately after the re-estimation of future cash flows?
c. On January 2, 2009, the day following the cotton production news release, a competitor announces plans to build a synthetic fabrics plant to open in three years. Levi Strauss keeps its 2009 to 2011 estimates but reduces the estimated annual cash flows for subsequent years to $2,000,000. What is the value of Lei Strauss’s plant on January 1, 2009, after the new projections?
d. On January 2, 2009, an investor contacts Levi Strauss about purchasing a 20% share of the plant. If the investor expects to earn at least a 12% annual return on the investment, what is the maximum amount that the investor should pay? Assume that the investor and Levi Strauss both know all relevant information and use the same estimates of annual cash flows described in part c.
Required:
Using future value and present value techniques, including perpetuities to solve a variety of realistic problems, we give no hints as to the specific calculation with the problems.