Tony Skateboards is considering building a new plant. James Bott, the company's marketing manager, is an enthusiastic supporter of the new plant. Alyssa Minh, the company's chief financial officer, is not so sure that the plant is a good idea. Currently the company purchases its skateboards from foreign manufacturers. The following figures were estimated regarding the construction of a new plant.
Cost of plant $4,000,000 Estimated useful life 15 years
Annual cash inflows 4,000,000 Salvage value $2,000,000
Annual cash outflows 3,550,000 Discount rate 11%
James Bott believes that these figures understate the true potential value of the plant. He suggests that by manufacturing its own skateboards the company will benefit from a "buy American" patriotism that he believes is common among skateboarders. He also notes that the firm has had numerous quality problems with the skateboards manufactured by its suppliers. He suggests that the inconsistent quality has resulted in lost sales, increased warranty claims, and some costly lawsuits. Overall, he believes sales will be $200,000 higher than projected above, and that the savings from lower warranty costs and legal costs will be $80,000 per year. He also believes that the project is not as risky as assumed above, and that a 9% discount rate is more reasonable.
Answer each of the following.
(a) Compute the net present value of the project based on the original projections.
(b) Compute the net present value incorporating James' estimates of the value of the intangible benefits, but still using the 11% discount rate.
(c) Compute the net present value using the original estimates, but employing the 9% discount rate that James suggests is more appropriate.
(d) Comment on your findings.
The problem set deals with calculating the net present value, of an investment choice, under different circumstances.