Recent biotechnological research has made possible the development of a sensing device that implants living cells on a silicon chip. The chip is capable of detecting physical and chemical changes in cell processes. Proposed uses of the device include researching the mechanisms of disease on a cellular level, developing new therapeutic drugs, and substituting for animals in cosmetic and drug testing. Biotech Device Corporation (BDC) has just perfected a process for mass-producing the chip.
The following information has been compiled for the board of directors:
• BDC's marketing department plans to target sales of the device to the larger chemical and drug manufacturers. BDC estimates that annual sales would be 2,000 units if the device were priced at $95,000 per unit (in dollars of the first operating year).
• To support this level of sales volume, BDC would need a new manufacturing plant. Once the "go" decision is made, this plant could be built and made ready for production within one year. BDC would need a 30-acre tract of land that would cost $1.5 million. If the decision were to be made, the land could be purchased on December 31, 2009. The building would cost $5 million and would be depreciated according to the MACRS 39-year class. The first payment of $1 million would be due to the contractor on December 31, 2010, and the remaining $4 million on December 31, 2011.
• The required manufacturing equipment would be installed late in 2011 and would be paid for on December 31, 2011. BDC would have to purchase the equipment at an estimated cost of $8 million, including transportation, plus a further $500,000 for installation. The equipment would fall into the MACRS seven-year class.
• The project would require an initial investment of $1 million in working capital. This investment would be made on December 31, 2011. Then on December 31st of each subsequent year, net working capital would be increased by an amount equal to 15% of any sales increase expected during the coming year. The investments in working capital would be fully recovered at the end of the project year.
• The project's estimated economic life is six years (excluding the two-year construction period). At that time, the land is expected to have a market value of $2 million, the building a value of $3 million, and the equipment a value of $1.5 million. The estimated variable manufacturing costs would total 60% of the dollar sales. Fixed costs, excluding depreciation, would be $5 million for the first year of operations. Since the plant would begin operations on January 1, 2012, the first operating cash flows would occur on December 31, 2012.
• Sales prices and fixed overhead costs (other than depreciation) are projected to increase with general inflation, which is expected to average 5% per year over the six-year life of the project.
• To date, BDC has spent $5.5 million on research and development (R&D) associated with cell implantation. The company has already expensed $4 million in R&D costs. The remaining $1.5 million will be amortized over six years (i.e., the annual amortization expense will be $250,000). If BDC decides not to proceed with the project, the $1.5 million R&D cost could be written off on December 31, 2009.
• BDC's marginal tax rate is 40% and its market interest rate is 20%. Any capital gains will also be taxed at 40%.
(a) Determine the after-tax cash flows of the project in actual dollars.
(b) Determine the inflation-free (real) IRR of the investment.
(c) Would you recommend that the firm accept the project?