Mini Case 3-1: Toronto Enterprises Limited

Toronto Enterprises Limited (TEL) has been evaluating an investment project that will use a warehouse it currently owns but not using. This project will require an immediate capital expenditure of $1 million for the required equipment. The unused warehouse will require very little work for the equipment to be put into operation. TEL has no other intended use for the warehouse, but the company has been renting it for $70,000 a year.

For the project, TEL will also use an equipment that was purchased a year ago for $525,000, but which has yet to be used. The equipment is highly technical, and TEL has no use for it. Over the year of ownership, the equipment has significantly declined in value. If TEL were to sell the equipment, the most they would receive $300,000. The equipment has yet to have any CCA charged against the original purchase price.

The incremental operating income for the project is expected to be $375,000 a year for 6 years and then will increase to $425,000 a year for another 6 years. At the end of the project life all the equipment used for the project is expected to have a market value of only $100,000.

With the sales increasing, TEL will be required to invest an additional $160,000 in current assets. Accounts payables and accruals are expected to increase by a total of $60,000. The CCA rate for all equipment is 30 percent. The tax rate for TEL is 40 percent and the cost of capital needs to be calculated from the common size Balance Sheet below:

Current Asset $ 20% Current Liabilities 10%

Net Fixed Assets 80% Long-term Debt 30%

Common Equity 60%

Total Assets 100% Liabilities & Equity 100%

The required return for the common shareholders is 18% and TEL management has established a risk adjustment factor of 1.25 for investment purposes.

Required:

1. Should TEL proceed with the new project? (10 Marks)
2. Determine their IRR for this project ( 3 Marks)
3. If the cost of capital was not constant over the life of the project,

how could this be addressed within your analysis? ( 2 Marks)