Question

Numbers Matter is in a charming but slightly antiquated facility in downtown Charleston. Once a cotton warehouse, the building has beautiful beamed ceilings and natural light from a glassed-over atrium. In the spring and fall, the building is tolerably well ventilated, but winters are chilly and summers (yes, climate change is real!) very uncomfortable. The firm is considering a major infrastructure overhaul that would renovate the inadequate air-conditioning system and provide updated routing for a state-of-the-art IT, security, and communications system. The new system will cost $950,000, Shipping and installation is estimated at $49,000. Post-renovation costs (re-painting, new carpeting, ceiling tiles, etc. are estimated at $28,250.The past two hurricane seasons wreaked havoc on the roof, and the firm spent approximately $75,000 on repairs. Numbers Matter owns the building, and rents out the entire 3rd floor to law firms and investment bankers. With the renovation, they are confident that they can enhance the lease revenues by approximately $1,350,000 per year. They also believe that they can sell the communications and security system hardware at the end of the 4-year project to a re-cycling facility for 6% of the original system cost. The fixed costs of operating the new system will be $27,500. The NWC is estimated to be 2.35% of the annual lease revenues. Numbers Matter will use the MACRS 3 schedule for determining depreciation. During the investment and construction phase and during the life of the project they will lose the revenue from one office --- the equipment mainframe and the maintenance staff will require the space. Currently they reap $25,000 annual lease income from this office. A leading real estate expert has projected that there is a 60% chance that they will reach their target of $1.35 million in annual lease revenues. However, the expert has added that there is a 25% chance that the increased supply of office space on the peninsula will exert downward pressure on lease revenues, and that the firm will only glean $900,000 lease revenues annually. On the upside, the expert has pointed out that the location, amenities and beauty of the building could attract major deep-pocket accounting and financial services firms. In this case, there would be a 15% chance of achieving $1.6 million in annual lease revenues. Numbers Matters is subject to a 35% marginal tax rate. Create a FCF analysis, using NPV, IRR, MIRR, PB, DPB, PI. Use the correct cost of capital in your analysis. Advise the firm whether or not to undertake this renovation project. The grumpy board member still insists upon a two-year pay-back period. Use your skills to make the best presentation of this project and your recommendations.

Answer 1

Year	0	1	2	3	4
1.Initial cost+installation of secrity system	-999000
2.Renovation costs(amortised over 3 yrs. As benefits accrue in future yrs.(more than 1 yr.)	-28250
a.Beg.NWC reqd.	0	29962.5	29962.5	29962.5	29962.5
b.End.NWC reqd.	29962.5	29962.5	29962.5	29962.5	0
3.Change in NWC(a-b)	-29962.5	0	0	0	29962.5
4. After-tax sale value(999000*6%*(1-35%))					38961
5.Expected annual revenues		1275000	1275000	1275000	1275000
(60%*1350000)+(25%*900000)+(15%*1600000)
6.Fixed opg. Expene		-27500	-27500	-27500	-27500
7.Loss of lease revenue		-25000	-25000	-25000	-25000
8.Income before tax(5+6+7)		1222500	1222500	1222500	1222500
9.Tax at 35%(8*35%)		-427875	-427875	-427875	-427875
10.Income after tax(8-9)		794625	794625	794625	794625
Depn.Tax shields(33.33%, 44.45%,14.81%&7.41%
11.System		116538	155419	51783	25909
12.Renovation costs		3296	4395	1464	733
13.Operating cash flow(10+11+12)		914459	954439	847873	821267
14. Total annual cash flows(1+2+3+4+13)	-1057213	914458.8	954439.4	847872.5	890190.2
IRR=	78%

15.Cumulative cash flows	-1057213	-142754	811686	1659558	2549749
Payback period=
1+(142754/811686)=
1.18
years