The ProBuilder Company is considering the introduction of a new product line which will require the construction of a new plant and equipment, estimated to cost $8,000,000 plus $600,000 for shipping and installation. Depreciation will be the straight line method to zero over 10 years. ProBuilder acquired the land on which the plant is to be built a year ago for $500,000, but land prices have risen 15% since then. On termination of the project, it is expected that the land could be sold for $1,100,000.
If the project goes ahead additional working capital equal to 40% of annual sales revenue will be required. Assume the initial working capital is required immediately (T0), and that any subsequent changes also occur at the beginning of each period. Sales revenues are estimated to be $1,000,000 in Year 1, $2,000,000 in Year 2, and $5,000,000 in Years 3 - 10.
Corresponding cash operating are $800,000, $1,250,000 and $2,000,000. ProBuilder expects fixed costs to be $75,000 per year.
i. If the tax rate is 30%, and the cost of capital is 14.5%, should the new product be introduced?
ii. If inflation is expected to average 5% over the next 10 years, does it appear that the project's cash flow estimates are real or nominal? Is the 14.5% cost of capital a real or nominal rate? Is the current NPV biased, and if so, in which direction?
The solution explains how to make the decision whether to new introduce the new product or not using capital budgeting analysis