You have recently been hired by Intersoll Motors Inc. (IMI) in its relatively new treasury management department. IMI was founded eight years ago by Geoff Boycott. Geoff found a method to manufacture a cheaper battery that will hold a larger charge, giving a car powered by the battery a range of 700 km before requiring a charge. The cars manufactured by IMI are midsized and carry a price that allows the company to compete with other mainstream auto manufacturers. The company is privately owned by Geoff and his family and it had sales of $10 million last year. Cost of goods sold totalled $8M and depreciation was $1M. IMIs growth to date has come from its profit. When the company had sufficient capital, it would expand production. Relatively little formal analysis has been used in its capital budgeting process. Geoff has just read about capital budgeting technique and has come to you for help. For starters, the company has never attempted to determine its cost of capital, and Geoff would like you to perform the analysis. Because the company is privately owned and not yet publicly traded, base all weights on the book values instead of the market values. IMIs capital is made up of a bank loan and owners equity. It has a 25-year loan for 1,500,000 with an APR of 8.15% based on semi-annual compounding. IMI has been paying monthly for 8 years. Before the company added debt, the cost of equity was 15%. The firms marginal tax rate is 35% and this is expected to continue indefinitely.

IMI has been exploring some growth opportunities. One opportunity that looks promising is a new factory that can produce battery operated Sports Utility Vehicles or SUVs. SUVs are currently very popular with young families and the demographic is expected to continue to grow. The problem is that many consumers are not convinced a battery alone will provide the sufficient mileage and would prefer a hybrid of gas/battery. A plant and warehouse, complete with equipment, that could produce hybrid SUVs is expected to cost $12.5M. All factory and equipment costs have a CCA depreciation rate of 20% and an expected salvage value of $2.17M at the end of the projects life in 8 years. The tax rate is assumed to stay constant at 35%. Hybrid SUVs sell for $60,000 with a production cost of $50,000. Fixed costs are expected to be $1,500,000 annually. Net working capital is expected to be $20% of the expected growth in sales for the next year. IMI expects the project to recover its net working capital in the last year. IMI expects to be able to produce and sell 525 SUVs a year and expects unit sales to increase by 10% per year after the first year. At a board meeting, the VP of Marketing indicates that the company spent $150,000 on a marketing study that determined the expected future care sales. The VP of Operations mentions that IMI owns an empty warehouse that is currently on the market for $1,200,000. Instead of selling it, it could easily be converted to a new plant, saving the project money.

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After the meeting, IMI decides to go ahead with the new factory. At your next meeting, another team member suggests that there may be an opportunity to expand the factory later if demand is higher than expected. Given the uncertainty of demand for battery powered SUVs in the future, this seems like an appealing option. You gather the following details (note, some simplifications of the original factory have been made): The original factory is set up to produce 525 SUVs per year. This factory is not large enough to increase its capacity beyond this unless the property also for sale next door is purchased at the same time for an additional $5M and is expected to be sold at the end of the project for 6M. The original factory still expects to sell the Hybrid SUVs for $60,000 with production costs of $50,000. Fixed costs are expected to be $1,500,000 annually. Your WACC is 13% and the marginal tax rate is 35%. Capital gains tax is 40% and only taxed on half the gain. If demand for Hybrid SUVs increases, staring in year 3, the additional property could be developed for an additional $6M (in addition to the property purchase price) to double capacity to 1,050 SUVs per year (starting in year 4) for the remaining 5 years of the projects life*. Under the expansion, all associated costs would double except for fixed costs which are expected to be only an additional 1,000,000 per year for the expansion. At the end of the project, the development is expected to be worth $1,000,000. *Property development costs occur in year 3 but all related income and expenses, including depreciation, would occur in years 4-8. Geoff tasks you with determining whether the expansion option is a good investment for the company. Part 3: For the expansion, assume there is no sales growth rate or net working capital. a. Recalculate the base NPV of the projects without the extra property purchase, NWC, or sales growth. b. Based on the CCA rules, should the neighbouring land purchase be depreciated (assume it is free of structures)? If so, use a rate of 8% per year. c. Based on CCA rules, should the property upgrades in year 3 be depreciated? If so, use a CCA rate of 20%. d. If there is a 60% chance that the demand for hybrid SUVs increases in 3 years, is it worthwhile to buy the additional property today?