Question
You work for Hedvig Mopeds Co., which manufactures the world's finest city mopeds. After spending $1.5 million on marketing survey, your boss has decided to
You work for Hedvig Mopeds Co., which manufactures the world's finest city mopeds. After spending $1.5 million on marketing survey, your boss has decided to grow the firm by producing a new moped line "Ariel".
The project has an anticipated economic life of 5 years. To produce "Ariel", your company will build a new factory in Lantau Island. The factory will cost HK$12 million today and has a salvage value of $3 million. You plan to use straight-line depreciation and depreciate the factory to a book value of $2 million in 5 years.
You expect annual sales of mopeds to be $18 million in years 1 through 5 and total (fixed and variable) costs to equal 70% of annual sales. You also project that 40% of those revenues will come from your existing customers switching from old mopeds, which also had costs equal to 70% of sales.
If the company goes ahead with the proposed project, it will require an immediate increase in current assets of $2.5 million but will also result in an immediate increase of $1 million in current liabilities. Any change in net working capital that occurs at the beginning of the project will be recovered at the end of the project. The company's annual interest expenses are $800,000.
The corporate tax rate is 20%. Hedvig Moped's weighted average cost of capital is 11%.
Assume all sales revenue is received in cash, all operating costs and income taxes are paid in cash, and all cash flows occur at the end of the year.
a) Calculate relevant cash flows for this project in years 0 through 5.
b) What is the net present value of this project? Should the company introduce this new product line? Why?
c) If instead managers choose to depreciate the factory to a book value of 0, would the NPV be higher or lower? Please briefly explain.
d) Assume that you have the option to sell the factory for $6 million at the end of Year 4 and quit the business (so no cash flows in year 5). What is the NPV of building the factory, running it for 4 years, and then selling the factory for $6 million at the end of year 4? (This question is independent of part c.)
e) It turns out that if the company introduces this new product line, it needs to use an existing structure that the company built 3 years ago for $4 million. You figure out that this existing structure can be rent for the equivalent of $0.3 million each year. Does this affect your decision? (This question is independent of part c and part d.)
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