A positive NPV investment is an economic rent. That is, firms cannot rely on same types of projects/products to add on to shareholders/owners wealth indefinitely. Multiverse Incorporation (MI) is a small-sized and yet well-established company which successfully provides printing services to businesses/schools/organisations for generations. However, the increasing trend of online documents and viewings among MI clients in its area has urged the MIs management to reassess its business position and to adjust to the new way of the industry accordingly. The management team of MI has asked you, a financial consultant, to evaluate the proposal to expand its business into IT software/solution (full-cycle services including maintenances) for online document creations/viewings) that would address the demand in this changing market.

The existing printery (print shop) is now operating at its 80% capacity and cannot be expanded beyond its 100% capacity. At the same time, the demand for existing products (hard copy prints) is expected to reduce slowly at least in the next five years (estimated as 2% per year). Unfortunately, the rest of capacity (20%), as well as floor space and utilities in place will not be suitable in facilitating the expansion of the new project (IT solutions) in consideration. In fact, to create a modern appeal to the new online and IT trend, the company will need to rent a much more expensive office/facility in CBD (central business downtown) for the next five years and this will push to total building lease for the whole company to $100,000 per year. Some of the existing furniture (relatively newer ones) at the print shop can be used at the new site. However, new equipment (including new computers and gadgets needed) worth $400,000 will need to be acquired to establish this new line of operation. To provide these IT services, MI management decides that the company will hire IT professionals on project by project basis. These IT sub-contractors will charge the service fees of 42.5% (e.g variable cost) fee to MI. These will be calculated based on how much MI can get from its clients as IT-related revenues. Also, the new line of business (IT solutions) will post a demand on existing (experienced) personnel at the print shop. Specifically, the decision is to reduce four experienced staffs of the existing print shop and move them to the new CBD office, going forward. This will have an adverse impact on the capacity of printing services and ultimately cause a significant reduction in revenues at the existing print shop.

The management team of MI has given a preliminary assessment on the viability of this project as follows:

Exhibit 1

Preliminary Profitability Estimates

IT Software/Solution Expansion

Revenues (per year) $1,000,000

Cash Expenses (per year)

Cost of goods sold (IT services of contractors) $425,000

Building lease	90,000
Marketing expenses	12,000
Other expenses	30,000
Total expenses		$557,000
Contribution to profit		$443,000

Equipment Required

New equipment to be purchased	$400,000
Old furniture to be moved	20,000 t((trick
Cost of moving and decoration	1,000
Total capital cost		$421,000

Payback period = $421,000/$443,000 = 0.95 years

Note:Contractors service fees are estimated around 42.5% of services charged to clients.

Viewing the above Exhibit, you immediately realised that there are several flaws and unrealistic assumptions with the analysis. The attractiveness shown by0.95years figure (the payback period for the printing industry is three years) could be misleading. As a result, you seeked further information which should be relevant to the decision at hand. Exhibit 2 provides the additional information accordingly.

Exhibit 2

Estimated Sales and Marketing Expenses

	Annual Revenues (estimated for year 1)	Annual Marketing Expenses (assumed constant)
Existing print shop No expansion to IT solution	$ 1,200,000	11,000
Existing print shop- With Expansion to IT solution With new product	$ 1,000,000	11,000
IT solution services
year 1	$ 500,000	$15,000
Year 2	750,000	13,000
Year 3 and after	1,000,000	12,000

Estimated Production Cost

	Printing Costs	Annual Fixed Costs Lease Depreciation* Other
Existing printery section	$900,000	$10,000 $ 10,000# $ 6,000
IT solution services section Year 1		$90,000 $66,666.67 $24,000
Year 2		$90,000 $66,666.67 $24,000
Year 3		$90,000 $66,666.67 $24,000
Years 4-5		$90,000 $66,666.67 $24,000

* These amounts are for reporting purposes ONLY and are based on a 6-year life, straight-line rates, and zero salvage values.

^# For only year 1 and year 2 based on existing furnitures. All other fixed assets have already been fully depreciated.

In addition, with the existing operations, MI has to keep the curren assets balance over the current liabilities by $42,000. With Status quo, there will be no need to increase this balance for the next five years. However, if the IT solution services are to be undertaken (e.g. the move is made), a total balance of $75,000 (e.g current assets beyond what are financed by current liabilities) will be needed in the first year, rising to a total balance of $104,000 in Year 2. FromYears 3 onwards, thetotal balance is estimated as $134,100.

Regarding the furniture that is to be moved from the printery to the new office in CBD, this is all still in good shape and can be used for up to six years. It is still on the books at a value of $20,000, and the depreciation is $10,000 per year for the next two years. It will cost $1,000 to move it to the new office. The market price of these furnitures is $18,000 but MI will not sell them anyway (e.g. regardless of pursuing IT Solution services or not). To buy brand new furniture of the same quality though will cost over $ 45,000. The capital gain tax rate on selling assets is the same as corporate tax rate.

As for the standard analysis, the project will be considered based on a five-year analysis. At the end of five years, the market value of the equipment at the IT solution office is estimated to be $40,000, and it is assumed that thefull value of the incremental working capital accumulated for IT Solution service section can be recovered. The salvage value for the purpose of depreciation calculation is zero(e.g. at the end of the 6^th year, the value of the new equipment in the decision, will be zero in the accounting book).

The corporate tax rate is 28 percent. MI has a policy of using straight-line depreciation for reporting purposes but ACRS depreciation for tax calculations. Under the ACRS guidelines, the new equipment is classified as a five year asset. The ACRS depreciation schedule is:(depreciation is high at first stages tax)

Year 1	Percent 20%
2	32
3	19
4	12
5	11
6	6

Finally, the weighted average cost of capital of MI has been using for its capital budgeting purposes is 12 percent (per year). discount rate

QUESTIONS

1. Critique the profitability analysis shown in Exhibit 1. Identify (and briefly discuss) two shortcomings you can identify in the context of incremental cash flows (e.g. also look at Exhibit 2).

(1 point)

2. Calculate the relevant cash flows of the IT solution project for each of the five years to be used in your capital budgeting analysis. Also assume that the $1,000 moving, and decoration cost can be written off immediately.

(Tips: In designing the Excel template for this question, please make sure that you consider Question 5 below. That is, you need to link the % charged by IT sub-contractors (e.g. 42.5% as the base case) cell to your cash flows and thus NPV calculations.)