Jack Tar ,CFO of S&H Inc, opened a confidential envelope.It contained a draft of a competitive bid for a contract to supply duffel canvas to the U.S. navy.The CEO of S&H company asked Mr.Tar to review the bid before it was submitted.The bid was prepared by the sales staff. It called for S&H to supply 100,000 yards of duffel canvas per year for 5 years.The proposed selling price was fixed at $30 per yard.The bid was unusual in two aspects.First, if accepted by the navy,it would commit the company to a fixed price, long-term contract.Second, producing the canvas would require a investment of $1.5 million to purchase machinery and to refurbish the companys plant at Pleasantboro, Maine.

1.Tha plant at Maine had been built in the early 1900s and is now idle.The plant was fully depreciated in the books ,except for the purchase of land in 1947 for $10,000.

2.Now that the land is valuable,the plant could be sold immediately or in the near future for $600,000.

3.Refurbishing the plant would cost $500,000.This investment could be depreciated on a 10 year schedule using accelerated depreciation.

4.The new machinery would cost $1 million.It will be depreciated on a 5-year schedule.

5.The refurbished plant and new machinery would last for many years.However, the market for duffel canvas is small and it is not clear that additional orders could be obtained once the navy contract is finished.The machinery is custom-built and could be used only for duffel canvas. Its second hand value 5 years later would probably be zero.

6.Working capital is 10% of sales.

The following table shows the forecasts for income from the contract except that the forecast used straight line depreciation.Estimates of accelerated depreciation was as follows:

Notes:

COGS includes fixed costs of $300,000 per year plus variable costs of $18 per yard .Costs are expected to rise at 4% per year.

Depreciation includes $1 million investment depreciated over 5 years and $500,000 cost of refurbishing depreciated for 10 years.

Required:

1.Construct a spreadsheet to estimate the cash flows,using the above accelerated depreciation figures, and calculate the NPV of the investment.Use 12% as the discount rate. Calculate NPV assuming sale of the land for $ 600,000 five years later after the investment is completed ,since immediate sale of land can not posible if investment is undertaken.

2.Mr.Tar received an offer from a real estate developer to purchase the land and the plant at Pleasantboro for $1.5 million in cash. Evaluate the decision of selling the land for $1.5 million today or making the investment as in part (1).Which is a better option?

3.Assume land can be sold for 1,500,000 today.Evaluate the alternative of selling the land 5 years later, assuming an inflation rate of 4% per year.How would that affect project NPV?

4.Compare the NPV you found in part (3) with the immediate sale of land and plant for $1.5 million.Which option is better?

5.What is the impact of inflation on cash flows of the project? Why does the CFO use accelerated depreciation?

6.Does the nominal discount rate of 12% include an inflation premium? How does constant price guarantee affect NPV of the project? How can inflation distort NPV calculations?

7. Explain the effects of inflation on investment decisions.