Question

The Blah Blah Blah (BBB) company is an online retailer.  You have been hired as the company’s new Director of Finance.  On your first day at work, you are call into the Management Team meeting.  BBB is evaluating building a new $50 million warehouse facility.  The facility is expected to have an economic life of 25 years and at that time, it is estimated, the facilities will be sold for $188,895.  The building will be depreciated with a CCA of 20%.  There are no other depreciable assets for this investment.  Inventory held in the facility will be approximately 10% of the next year’s sales.  There will be no other effect to Working Capital.

Sales from the new facilities are expected to be $30 million per year and are expected to grow at 3% annual. Contribution Margin is expected to be maintained at 25%.  Fixed costs, excluding depreciation, is expected to be $1.5 million.  These costs are expected to grow inline with inflation at 2%.

The CEO wants to know your opinion of if the facility makes sense financially, considering the company typically gets a return on its assets (ROA) of 8%.  He would like your answer within an hour.

You can feel the entire Management Team watching you as you walk out of the meeting room.  You scramble back to your office.  After banging your head on your desk for 5 minutes, you notice that you have BBB’s consolidated financial statements for 2019 on your desk:

As you look up from the financial statements, you notice that your screen saver has a continuous feed of financial market information for BBB – you see that the current price for BBB’s common shares is $37.35, its preferred shares is $102.04 and its 25 years bonds is $1,025.35.

As you reach into your briefcase to grab your lucky calculator, you notice the newspaper article that you were reading on your way into work about BBB – you highlighted one sentence:  “With GIC rates remaining stagnant at 2.85% and the markets expected return of only 7%, companies with average risk, like Blah Blah Blah, need to invest their money wisely.”  Beside the highlight is a note that you wrote, “BBB has a beta of 1”.

Suddenly, you feel the urge to start banging your head on your desk again …

Required:  Based on a Net Present Value and Internal Rate of Return (IRR) calculations and analysis (please show your work), write a short memo to the CEO and the rest of the Management Team commenting on WHY the new facility makes financial senses or not.

Answer 1

Based on Information Provided

Amount in $ Mn Cost 50 CCA Depreciation 20% Declining Value Inventory Held 10% of Next years sales Sales 30 Growth in sales 3% Per year Rate of Interest 8% Life of Asset 25 years Contribution margin 25% Fixed cost Inflation 2.0% Residue Value 0.19 Required Rate of Return is 8% Solution Year Formula 10 1 2 Sales (3% increase in each year) 30.0 30.9 Contribution (a) b=25% of a 7.5 7.7 Fixed Cost 2% inflation -1.5 -1.5 Inventory Holding Cost(10%*Sales*Cost of Capital) 10%*a*8% 10% -0.2 -0.3 Depreciation(CCA of 20%) 20% -10.0 -8.0 Cash flow -50.0 -40.0 32.0 Residual Value a Net Margin/ Cash Flow(g)=(e)-(1) -50.0 -42 -2.1 Investment -50.0 Cost of Capital 8% NPV @8% -50.0 -3.9 -1.8 25 NPV | 3 31.8 8.0 -1.6 -0.3 -6.4 -25.6 4 32.8 8.2 -1.6 -0.3 -5.1 -20.5 5 33.8 8.4 -1.6 -0.3 -4.1 -16.4 6 34.8 8.7 -1.7 -0.3 3.3 -13.1 7 35.8 9.0 -1.7 -0.3 -2.6 -10.5 8 36.9 9.2 -1.7 -0.3 -2.1 -8.4 9 38.0 9.5 -1.8 -0.3 -1.7 -6.7 10 39.1 9.8 -1.8 -0.3 -1.3 -5.4 | 11 40.3 10.1 -1.8 -0.3 -1.1 -4.3 12 41.5 10.4 -1.9 -0.3 -0.9 3.4 13 42.8 10.7 -1.9 -0.4 -0.7 -2.7 14 44.1 11.0 -1.9 -0.4 -0.5 -2.2 15 45.4 11.3 -2.0 -0.4 -0.4 -1.8 16 46. 7 11.7 -2.0 -0.4 -0.4 -1.4 17 48.1 12.0 -2.1 -0.4 -0.3 -1.1 18 49. 6 12.4 -2.1 -0.4 -0.2 -0.9 19 51.1 12.8 -2.1| -0.4 -0.2 -0.7 20 52. 6 13.2 -2.2 -0.4 -0.1 -0.6 21 54. 2 13.5 -2.2 -0.4 -0.1 -0.5 22 55.8 14.0 -2.3 -0.5 -0.1 -0.4 23 57.5 14.4 -2.3 -0.5 -0.1 -0.3 24 59.2 14.8 -2.4 -0.5 -0.1 -0.2 15.2 -2.4 -0. -0.2 0.2 13.0 -0.3 1.2 2.4 3.5 43 5.1 5.8 6.3 6.8 7.3 7.8 8.2 8.6 8.9 9.3 9.7 10.0 10.4 10.8 11.1 11.5 11.9 -0.2 0.9 1.7 2.2 2.5 2.8 2.9 2.9 2.9 2.9 2.9 28 27 26 25 24 23 22 2.1 2.0 2.0 1.9 1.9 IRR 7.46%

Note to Management:

Even though the NPV is negative when calculated at a return at 8% per annum however IRR is 7.46% which is higher than market expected rate of return of 7%.

Considering the CAPM Model, Expected rate of return is also 7%(Considering the Beta of the company is 1). Hence it is advisable to go for the investment.