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

2. 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 through 2020.
Expected sales and unit sales price are given as follows:

3. 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

4. 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.  

5. 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

6. 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
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

7. 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%

8. 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
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%

9. 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

10. 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%