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    Net Present Value Analysis with Opportunity Revenues and Costs

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    A steel company has an existing furnace that will last for another 10 years. The company is evaluating a proposal to refurbish the existing furnace. You have just completed a $1m feasibility study and have found the following: Refurbishing the furnace will result in $50m in new sales per year and will save $90m per year in expenses (over the next ten years). Suppose the new equipment costs $1,000m and uses some (fully-depreciated) parts that are not currently in use but could be sold elsewhere for $30m. The existing (non-refurbished) furnace and the refurbished furnace will both last for 10 years at which time the non-refurbished furnace will have a salvage value of $0 and the refurbished furnace will have a salvage value of $200m. The project will require $20m of extra working capital over the next 10-year life of the project, beginning at time zero through time 9. That is the level of working capital on the balance sheet with the refurbished furnace will be higher that the level without the refurbished furnace.

    Suppose the firm uses straight-line depreciation for tax purposes (so that the cost of refurbishing is completely depreciated over ten years) and pays 35% in corporate income taxes. Finally, suppose that the opportunity cost of the firm's investors is: r = 10%.


    1) What is the NPV of refurbishing the furnace?
    2) Should the firm continue with the old furnace or proceed with refurbishing the furnace?

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    Solution Summary

    This solution illustrates how to incorporate opportunity costs and revenues into a net present value analysis.