Project 1: Expanding Existing Capabilities

The first project is to increase Automaton's manufacturing capacity for five years.Automaton's Chief Financial Officer, Patrick McCabe believes doing this would boost Automaton's market share in the long run.

To facilitate this temporary expansion, Automation will purchase new equipment for $1,500,000.The additional micro-processors will be manufactured in a building Automaton purchased eight years ago for $4,200,000.The building will be retooled for the new project at a cost of $500,000, which includes building permit fees of $25,000.

The purchased equipment will be depreciated using Modified Accelerated Cost Recovery System (MACRS) depreciation schedule (see exhibits), and sold for $250,000 in year 5.

The projected revenue for year 1 is $550,000.Subsequent year's revenues will increase by eight percent of the preceding year's revenues (i.e., year 2 revenues equals 1.08 * $550,000).This expansion project will result in an annual loss of revenues from an existing manufacturing operation of $100,000.Operating expenses (excluding depreciation and amortization) is estimated at 20 percent of net revenues.

Operating net working capital will rise by $250,000 and $300,000 in years 1 and 2, respectively.This investment in operating net working capital fully reverses in the final year of the project.Annual interest expense is fixed at $35,000.

Questions

1. Is Kofi's first mental note accurate?Discuss briefly.
2. Is Kofi's second mental note accurate?Discuss briefly.
3. Is Kofi's third mental note accurate?Discuss briefly.
4. What is Automaton's cost of capital?
5. What is the project's net income for years 1 through 5?
6. What is the project's initial cash outlay in year 0?
7. What is the project's Free Cash Flows (FCF) for years 1 through 5?
8. What is the NPV and IRR of this project?
9. Kofi is concerned that the estimated cost of capital for Automaton is too high.He adjusts Automaton's Beta () and computes a new cost of capital of 5%.Using this discount rate, what is the project's NPV and IRR?