Nanovo 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. 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 to make a recommendation. Proposal 1 The current plant has a capacity of 25 000 cases per month. The first proposal is for a major expansion that would double the plants current capacity to 50 000 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 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. 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 also put forth a second proposal for a minor expansion that will increase the firms capacity by only 50%, to 37 500 cases per month. While the capacity is smaller, such an expansion would be cheaper and less disruptive. The smaller expansion will only require $2.4 million in new equipment, and $1.5 million in design and engineering expenses. The existing plant will only need to be shut down for four months. Sales, marketing and administrative costs will only increase by $500 000. Nanovo believes that with or without 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 its annual revenue. Nanovo pays a 30% 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 Nanovos shares. You have the following additional information about the shares. Nanovo has no debt and two million shares outstanding. The firms share price is $75. Analysts are expecting Nanovo to pay a $3 dividend at the end of this year, 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. (The use of Excel is optional but recommended.)

Case questions

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