22. The Paxton Homes Co. is a successful builder of moderate to high-priced houses.

The firm is currently considering an expansion into light commercial construction in which it would build shopping centers and small office buildings. Management considers the idea a new venture because of the major differences between commercial and residential construction.

Getting into the new line of business will require an investment of $12.5 million in equipment and $3 million in expenses. The equipment will be depreciated over five years. Part of the start-up money will come from the sale of some old trucks and cranes. These have a total market value of $1.8 million and an NBV of

$600 million. Selling the equipment will result in a depreciation reduction of

$200 million per year for three years.

Revenue from the commercial line is expected to be $6 million in the first year and to grow by $2 million in each succeeding year until it reaches $20 million.

After that, growth is uncertain and may be anywhere from 0 to 6% per year. Costs and expenses, including incremental overhead, will be 110% of revenues in the first year, 85% in the next two years, and 70% thereafter. Economies of scale in materials purchasing are expected to save the residential business about $250,000 per year but not until the fourth year. Net working capital requirements are estimated at 10% of revenue. The combined federal and state tax rate on the incremental business will be 40%. Losses can be offset against other profits and can therefore be viewed as earning a tax credit at the same rate. Paxton’s cost of capital is 12%.

You are a financial analyst assigned to evaluate the commercial construction proposal. Use the CAPBUD program to analyze the project and prepare a presentation in which you will make a recommendation either favoring or opposing its undertaking. Here are some ideas for approaches to your presentation.

a. Establish a base case using the information given. Forecast into the future until the numbers stop changing (eight years). Assume a terminal value based on a continuation of the eighth year’s cash flows with no further growth. Is the project acceptable based on NPV and IRR given these assumptions?

b. Test the sensitivity of the base case analysis to the terminal value assumption by varying the growth rate to 3 and 6%.

(1) Comment on the difference the terminal growth rate assumption makes.

(2) Construction is a cyclical industry in that it is very subject to the ups and downs of the economy. In good times growth is enormous, but in bad times the industry and the firms in it shrink rapidly. Given that fact, how do you feel about the terminal value assumption?

(3) Evaluate the project’s NPV and IRR assuming a 10-year planning horizon—

that is, assuming zero cash flows after the tenth year. Does this approach make more or less sense to you than the terminal value assumptions used in part (a)?

c. Test the sensitivity of the analysis to changes in revenue growth. For example, suppose revenue grows by only $1 million per year instead of two until the eighth year. Is the project a good idea then? What if cost/expense is a higher percentage of revenue than anticipated?