Question
Puffy Clouds, a maker of data storage products, is considering adding a new manufacturing facility. The new facility would be housed in an unused building
Puffy Clouds, a maker of data storage products, is considering adding a new manufacturing facility. The new facility would be housed in an unused building that the firm bought 8 years ago for $5 million; the building is being depreciated over a 20 life to a salvage value of zero. The building can be sold today for $2 million, and the market value of the building is expected to increase at 5% per year going forward. The new facility would require the purchase of $50 million of equipment that would be depreciated straight line to zero over a useful life of 5 years. However, the firm expects this equipment would have a scrap value of $250,000 at the end of its 5-year life. The firm would finance the equipment purchase with a five-year debt issue that would carry an interest rate of 5% p.a. The new facility would add $20 million to annual revenues, which are currently $100 million per year. The higher manufacturing efficiency of the new facility would reduce annual operating costs from 40% of revenues to 35% for both existing and new sales revenues. The new facility would require a $500,000 increase in inventories and create a $100,000 increase in accounts payable, which would be reversed at the end of the project. The firms tax rate is 20% and the required rate of return is 8%.
- What is the dollar amount of any opportunity costs that must be recognized in estimating the initial cash flow?
- How should we account for the cash flows associated with the debt issue used to finance the equipment purchase?
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