Nanovo Inc., is a manufacturer of low-cost micro batteries for use in a wide variety of compact electronic devices such as childrens toys, wireless transmitters, and sensors. The growth in the use of these devices has steadily increased, leading to an ever greater demand for Nanovos products. Nanovo has responded to this increase in demand by expanding its production capacity, more than doubling the firms size over the last decade. Despite this growth, however, Nanovo does not have sufficient capacity to meet the current demand for its ultra-long-life, low-voltage batteries. You have been asked to evaluate two proposals to expand one of Nanovos existing plants and make a recommendation.

The current plant has a capacity of 250,000 cases per month.

Proposal 1 The first proposal is for a major expansion that would double the plants current capacity to 500,000 cases per month. After talking with the firms design engineers, sales managers, and plant operators, you have prepared the following estimates:

Expanding the plant will require the purchase of $3.6 million in new equipment and entail up-front design and engineering expenses of $3.9 million. These costs will be paid immediately (at Year 0) when the expansion begins.

Installing the new equipment and redesigning the plant to accommodate the higher capacity will require shutting down the plant for nine months. During that time, the plants production will cease. After the expansion is finished, the plant will operate at double its original capacity. (The production shutdown will occur in Year 1.)

Marketing and selling the additional volume will lead to $1 million per year in additional sales, marketing, and administrative costs. These costs will begin in the first year (even while the plant is under construction and shut down).

Proposal 2 The engineers have put forth a second proposal for a minor expansion that will increase the firms capacity by only 60%, to 400,000 cases per month. While the capacity is smaller, such an expansion would be cheaper and less disruptive:

The smaller expansion will require only $2.4 million in new equipment, and $1.5 million in design and engineering expenses.

The existing plant will need to be shut down for only four months.

Sales, marketing, and administrative costs will only increase by $500,000.

Other information:

Nanovo believes that with or without any expansion, the technology used at the plant will be obsolete after six years and will have no salvage value, and the plant itself will need to be completely overhauled at that time. You also have the following additional general information:

With or without either proposed expansion, Nanovo will be able to sell all it can produce at an average wholesale price of $80 per case. This price is not expected to change during the next six years.

Nanovo has a gross profit margin of 55% on these batteries.

Nanovos average net working capital at the end of each year will equal 15% of the projected annual revenue next year.

Nanovo pays a 40% corporate tax rate. While all design and engineering costs are immediately deductible as operating expenses, all capital expenditures will be straight-line depreciated for tax purposes over the subsequent six years. Management believes the risk of the expansion is similar to the risk of Nanovos existing projects, and because Nanovo is all equity financed, the risk of the expansion is also similar to the risk of Nanovo stock. You have the following additional information about the stock:

Nanovo has no debt and has 2 million shares outstanding. The firms current share price is $75 per share.

Analysts are expecting Nanovo to pay a $3 dividend at the end of this year (i.e. D1=$3), and to raise its dividend at an average rate of 8% per year in the future. Based on this information, you have been tasked with preparing expansion recommendations for Nanovo.

Case Questions

1. Determine the annual incremental free cash flow associated with each expansion proposal relative to the status quo (no expansion).

2. Compute the IRR and payback period of each expansion proposal. Which plan has a higher IRR? Which has a shorter payback period?

3. Estimate Nanovos equity cost of capital. Use it to determine the NPV associated with each expansion proposal. Which plan has a higher NPV?

4. Should Nanovo expand the plant? If so, which proposal should Nanovo adopt? Explain.

5. If the Nanovos cost of capital is 16%, how would you choose between the two proposals? Explain.

6. Create the NPV profiles for both projects. The NPV of which of the two proposals is more sensitive to errors in the estimation of cost of capital? Explain.

Complete the calculations necessary for answering 1-6 in Excel. Use the templated provided.

7. Suppose Nanovo decides to do the major expansion. If investors are not expecting this expansion, and if they agree with the forecasts above, how will the stock price change when the expansion is announced?