Expansion Project Example Dr. C. Bulent Aybar Professor of International Finance

The Gomez Co. is considering an investment project The Gomez Co. is considering an investment project. Gomez has sufficient excess capacity in its plant to take on the project by making an investment in additional new equipment. The investment in land is $2 million; in plant is $8 million, subject to MACRS depreciation at 3 percent per year. The equipment cost is $10 million, and it qualifies in the five-year asset class under MACRS depreciation. The investment is expected to be completed at the end of 2014, and first project cash flows are expected to be generated at the end of 2015. The project life is six years over the years 2015 through 2020. Expected sales and unit sales price are given as follows:

Case Data Investment Outlay Land 2,000,000 Plant 8,000,000 Equipment 10,000,000 NWC Investment 800,000 Sales Volume Units Sales Price (Real USD) 2015 10,000.00 1,000 2016 14,000.00 2017 20,000.00 2018 25,000.00 2019 28,000.00 2020 30,000.00

The sales price per unit in 2015 real dollars will be $1,000 for each of the years. Cash operating costs are projected at 75% of sales. The applicable tax rate for Gomez is 34%. The project will require an initial working capital investment of $800,000 in 2014 and during the operational period net working capital will be 10% of sales. For instance, if Gomez’s expected sales in 2015 is $10,000,000, working capital requirement will be $1,000,000 and company will have to invest $200,000 in its net working capital to support its operations. Thereafter the incremental investment in in net working capital each year will be 10% of the sales increase. The total networking capital investment will be recovered at the end of the sixth year.  

Although no salvage value is taken into account in calculating MACRS depreciation , Gomez forecasts that the equipment will have a salvage value of $1 million at the end of 2020. Column1 Land Building Equipment Total Salvage Value Salvage values 2020 (2014 real dollars) $2,000,000 $6,680,000 $1,000,000 Initial cost 2,000,000 8,000,000 10,000,000 Depreciable basis 2014 Book value, 2020 6,680,000 Gain/Loss 1,000,000 Tax Liability/Credit 340,000 Net salvage values 660,000 9,340,000.00

Project Cash Flows 2014 2015 2016 2017 2018 2019 2020 Investment Outlay 1 2 3 4 5 6 Property, Plant & Equipment (20,000,000) NWC (800,000) Total Outlay (20,800,000) Unit Sales 10,000 14,000 20,000 25,000 28,000 30,000 Sales Price Real 1,000 Inflation 0% Sales Price Nominal Net Sales 10,000,000 14,000,000 20,000,000 25,000,000 28,000,000 30,000,000 Cash Operating Costs 7,500,000 10,500,000 15,000,000 18,750,000 21,000,000 22,500,000 EBITDA 2,500,000 3,500,000 5,000,000 6,250,000 7,000,000 Depreciation on Equipment 2,000,000 3,200,000 1,900,000 1,200,000 1,100,000 600,000 Depreciation on Building 240,000 Income Before Taxes 260,000 60,000 2,860,000 4,810,000 5,660,000 6,660,000 Tax (@34%) 88,400 20,400 972,400 1,635,400 1,924,400 2,264,400 Income After Tax 171,600 39,600 1,887,600 3,174,600 3,735,600 4,395,600 Depreciation 2,240,000 3,440,000 2,140,000 1,440,000 1,340,000 840,000 Change in NWCI (200,000) (400,000) (600,000) (500,000) (300,000) Cumulative NWCI (1,000,000) (1,400,000) (2,000,000) (2,500,000) (2,800,000) (3,000,000) Net Salvage Values - 9,340,000 Total Cash Flows 2,211,600 3,079,600 3,427,600 4,114,600 4,775,600 17,375,600

Project Evaluation: NPV and IRR Real Cost of Capital 7% Inflation Nominal Cost of Capital 0.07 NPV 4,876,741.78 IRR 12.24%

Project Cash Flows under 5% Inflation Assumption 2014 2015 2016 2017 2018 2019 2020 Investment Outlay 1 2 3 4 5 6 Property, Plant & Equipment (20,000,000) NWC (800,000) Total Outlay (20,800,000) Unit Sales 10,000 14,000 20,000 25,000 28,000 30,000 Sales Price Real 1,000 Inflation 5.00% Sales Price Nominal 1,050 1,103 1,158 1,216 1,276 Net Sales 10,000,000 14,700,000 22,050,000 28,940,625 34,034,175 38,288,447 Cash Operating Costs 7,500,000 11,025,000 16,537,500 21,705,469 25,525,631 28,716,335 EBDIT 2,500,000 3,675,000 5,512,500 7,235,156 8,508,544 9,572,112 Depreciation on Equipment 2,000,000 3,200,000 1,900,000 1,200,000 1,100,000 600,000 Depreciation on Building 240,000 Income Before Taxes 260,000 235,000 3,372,500 5,795,156 7,168,544 8,732,112 Tax (@34%) 88,400 79,900 1,146,650 1,970,353 2,437,305 2,968,918 Income After Tax 171,600 155,100 2,225,850 3,824,803 4,731,239 5,763,194 Depreciation 2,240,000 3,440,000 2,140,000 1,440,000 1,340,000 840,000 Change in NWCI (200,000) (470,000) (735,000) (689,063) (509,355) (425,427) Cumulative NWCI (1,000,000) (1,470,000) (2,205,000) (2,894,063) (3,403,418) (3,828,845) Net Salvage Values - 11,512,803 Total Cash Flows 2,211,600 3,125,100 3,630,850 4,575,741 5,561,884 21,519,414 Real Cost of Capital 7% 5% Nominal Cost of Capital 12.35% NPV 2,883,803.49 IRR 15.70%

Salvage Values with Inflation Column1 Land Building Equipment Total Salvage Value Initial Investment 2,000,000 8,000,000 10,000,000 Salvage Value 2,680,191 8,951,839 1,340,096 Book Value in 2020 6,680,000 - Capital Gain/Loss at Liquidation 680,191 2,271,839 Taxes 231,265 772,425 455,633 Net Salvage Value 2,448,926 8,179,414 884,463 11,512,803

Project NPV and IRR Real Cost of Capital 7% Inflation 5% Nominal Cost of Capital 12.35% NPV 2,883,803.49 IRR 15.70%