Tony Stark, CEO of CHI, wants you to evaluate two investment proposals that the company is considering:

An investment in manufacturing and distribution that involves the expansion of a facility and purchase of additional delivery trucks; and

The development of restaurants into several of its existing stores.

Mr. Stark reminds you that only relevant costs and revenues should be considered. "Relevant costs have to be occurring in the future," explained Mr. Stark. "And have to differ from the status quo. For example, if we choose to expand our facilities, it is only the incremental revenue and costs related to the expansion that should be considered. We also need to take into account the opportunity cost associated with the alternatives. For example, for the restaurant conversion, we need to factor in the lost sales".

More details on each investment proposal are included below. Mr. Stark wants you to recommend if CHI should invest in one, both, or none of the investment proposals.

Required Return

Mr. Stark wants you to use the weighted average bond yield for your required return. The total market value of debt CHI is expected to have going into this investment is $3.5B, which includes the additional $1.5B to be taken on that is not included in the current financial statements. The current outstanding debt has an interest rate of 5%, while the new debt's interest rate is now expected to be lower at 3%. All of the $3.5B in debt is in the form of bonds. Ignore income tax effects when calculating the required return (i.e., do not take the after-tax cost of debt). Use current interest rates as a proxy for bond yield.

Investment in Manufacturing & Distribution

Mr. Stark has decided that rather than purchase a distribution company, CHI will expand one of its current manufacturing facilities to help meet the growing sports apparel demand in Canada, including the delivery of these products to the existing store network.

The manufacturing facility currently operates at capacity, manufacturing 400,000 products annually that are ultimately sold in CHI stores within the fiscal year. The facility was purchased for $7,000,000 ten years ago. With the expansion, CHI will have the ability to double the amount of products it can produce. The company expects to increase production by 75% in the first year of expansion, followed by a steady annual 10% growth based only on incremental production (i.e., 10% growth excluding the original facility capacity). The average apparel product manufactured will be sold for $30, and the price is expected to increase by inflation annually, which is forecasted to be a steady 2% over the next ten years.

The direct materials and direct labour used to manufacture these products are 23% and 25% of sales, respectively. These costs as a percentage of sales are expected to remain consistent over the time horizon. Six additional supervisors with fixed salaries of $100,000 per year are also required. Insurance for the additional facility space and equipment is $80,000 per year. Other incremental manufacturing overhead costs (property taxes, maintenance, security, etc.) excluding depreciation are estimated to be $500,000 annually. Wages are expected to increase with inflation over the time period, while other fixed costs are expected to remain steady.

CHI would also need to purchase an additional seven delivery trucks for the incremental deliveries. The trucks would cost $100,000 each and would require $10,000 each in insurance annually. Transportation variable costs (gas, truck driver salaries, etc.) are estimated to be 15% of incremental revenue.

The expansion is expected to cost $9,000,000 which will be fully capitalized to the balance sheet. An additional $1,000,000 will also need to be spent on production equipment for manufacturing purposes. Mr. Stark wants to see if the project will reach profitability after 6 years, so he wants you to evaluate the return on investment in that period using the investment criteria of payback period, discounted payback period, NPV, IRR, and profitability index. The following table will help in the calculations of the tax shield for each of the assets:

Class CCA Rate Description

43 30% Machine and equipment to manufacture and process goods for sale

10 30% Automobiles, panel trucks, trucks, tractors, trailers

1 10% Buildings that use at least 90% of square footage for manufacturing & processing, including the expansion of these buildings

Tax Shield Formula:

Tax Shield Formula

Assume no salvage value when calculating the tax shields, and that the accelerated investment incentive that allows 1.5 times the prescribed rate (in the first year only) applies for each class. The tax rate Mr. Stark wants you to utilize is 25%. When calculating the tax shield, the present value should be in the same period as the initial investment (Year 0), which also means that deprecation (i.e., CCA) should not be taken from the cash flows in subsequent years since their tax shelter effects are already accounted for in the tax shield.

Investment in Restaurant Conversion

Mr. Stark also wants you to evaluate the potential of turning several existing stores into restaurants. Fifteen stores have been selected as candidates for store conversion. It will cost $580,000 to convert each store into a restaurant, with these costs being capitalized with a 6% applicable CCA rate. The average restaurant is expected to generate an additional $300,000 in after-tax cash flow every year. However, CHI will also lose the $230,000 in annual after-tax cash flow it was already earning from each of the fifteen stores. The fifteen stores were purchased for $1,000,000 each eight years ago. Mr. Stark wants you to evaluate the profitability of this investment after an eight year period using the investment criteria of NPV and profitability index.

Questions:

1. 1. Calculate the bond yield to utilize as your required return.

1. 2. make a summary narrative (i.e., a detailed description) of each proposal with detailed elements on the initial investment as well as the costs/revenues over the life of each of the projects. Identify which revenues and costs are relevant to your analysis, and which costs are irrelevant. Identify the time horizon for each investment.

1. 3. Calculate the after-tax cash flows during the life of each of the projects. Be sure to identify the total costs of ownership and deduct those costs from the benefits to arrive at the net cash inflow per year.

1.