Foam All is the leading producer of flexible polyurethane foam for the bedding, furniture, carpet cushion and automotive markets. Foam All is considering whether it should expand its production facilities to develop a new foam product for the cushioning and sealing of sensitive electronic equipment.

Production facilities for the new foam product would be set up in an unused section of Foam Alls main plant. New machinery with an estimated total cost of $3,300,000 would have to be purchased. Furthermore, Foam Alls net working capital will have to increase by $225,000 at the beginning of the project and another increase of $25,000 will be needed in year 2. All working capital will be recovered at the end of the project. The machinery has an economic life of 4 years; however, the company has to depreciate it straight-line to a zero salvage value over 6 years. The machinery is expected to have a salvage value of $250,000 after 4 years of use.

The section of the plant in which production would occur had not been used for several years and, consequently, had suffered some deterioration. Last year, as part of a routine facilities improvement program, $500,000 was spent to rehabilitate that section of the main plant. Lionel Hutz, the chief accountant, believes that this outlay, which has already been paid and expensed for tax purposes, should be charged to the project. His contention is that if the rehabilitation had not taken place, the firm would have had to spend the $500,000 to make the plant suitable for the foam project.

Foam Alls management expects to sell 1,000,000 pieces of foam in the first year and expects sales will grow by 10% per year in years 2 and 3 and by 5% in year 4. Management expects to be able to sell the foam at a wholesale price of $4.50 per piece in the first year, but $3.50 per piece would be needed to cover cash operating costs in the first year. After the first year, cash operating costs are expected to increase by 3% per year and management expects to be able to raise the wholesale price by 2% per year. Fixed costs are estimated to be $100,000 a year. In examining the sales figures, Lionel noted a short memo from Foam Alls sales manager, Carl Carlson, which expressed concern that the new project would cut into the firms sales of other foams. Specifically, the sales manager estimated that existing foam sales would fall by 5 percent if the new foam were introduced. Lionel then talked to both Carl and Lenny Lenoard, the production manager, and concluded that the new project would probably lower the firms existing foam sales by $100,000 per year, but, at the same time, it would also reduce production costs by $70,000 per year, all on a pre-tax basis. Foam Alls federal-plus-state tax rate is 40 percent and its overall cost of capital is 12%.

1. Should the $500,000 that was spent to rehabilitate the plant be included in the analysis?

2. Suppose another foam maker had expressed an interest in leasing the unused section of Foam Alls plant for $75,000 a year. If this were true (in fact it was not), on after-tax basis how would this information be incorporated into the analysis?

3. What is Foam Alls Year 0 total initial investment outlay on this project?

4. What is the expected after-tax salvage value of the machinery when the project is terminated at Year 4?

5. Estimate the projects operating cash flows for years 1-4.

6. What is the projects IRR and MIRR and should it be undertaken?