Question

36. Project Analysis Benson Enterprises is evaluating alternative uses for a three- story manufacturing and warehousing building that it has purchased for $2.16 million. The company can continue to rent the building to the present occupants for $50,000 per year. The present occupants have indicated an interest in staying in the building for at least another 15 years. Alternatively, the company could modify the existing structure and use it for its own manufacturing and warehousing needs. Benson's production engineer feels the building could be adapted to handle one of two new product lines. The cost and revenue data for the two product alternatives are as follows: PROD Initial cash outlay for building modifications Initial cash outlay for equipment Annual pretax cash revenues (generated for 15 years) Annual pretax expenditures (generated for 15 years) PRODUCT A PRODUCT B $114,000 $132,000 235,000 282,000 305,000 372,000 180,000 230,000 The building will be used for only 15 years for either Product A or Product Page 258 B. After 15 years, the building will be too small for efficient production of either product line. At that time, Benson plans to rent the building to firms similar to the current occupants. To rent the building again, Benson will need to restore the building to its present layout. The estimated cash cost of restoring the building if Product A has been undertaken is $65,000. If Product B has been manufactured, the cash cost will be $78,000. These cash costs can be deducted for tax purposes in the year the expenditures occur.

Answer 1

We would compute NPV for all the three alternatives:

a. continue to rent the building

b. Project A, or

c. Project B.

If all three of the projects have a positive NPV, then we need to consider the project with the highest NPV.

Following cash flows should not be considered in the incremental cash flow analysis.:

a. The remaining fraction of the value of the building and depreciation are not incremental costs and need to be excluded while doing the analysis of the two alternatives.

b. The $2,160,000 purchase price of the building is a sunk cost and should not be included.

c. Since we need to calculate the NPV of the future cash flows for each option, so the only cash flow today would be the building modifications required for Project A and Project B. If these costs are included, they would be reducing the NPV of all three options by the same amount, hence resulting in same conclusion.

d. The cash flows coming from renting the building after Year 15 are also not important costs since whatever alternative the company selects as of now, it would be renting the building after Year 15, so these cash flows would not be incremental for any of the options.

Option 1 : Calculation of the NPV for the decision to continue to rent the building :

Continue to rent:

Rent	$50,000
Taxes	17,000
Net income	$33,000

Since in this option, there would not be any incremental depreciation, the operating cash flow = the net income.

So, the NPV for the decision to continue to rent can be calculated using the below formula:

NPV = $33,000(PVIFA_12%,15)

NPV = $224,758.53

Option B. : calculation of the NPV for the decision to modify the building to produce Product A

a. The income statement for this modification would remain same for the first 14 years.

b. In Year 15, the company would be incurring an additional expense to convert the building back to its original form. This will be an expense in Year 15, which will make changes in the income statement.

c. The cash flow at Year 0 would be the cost of the equipment, and the cost of the initial building modifications, both of which would be depreciated on a straight-line basis.

Hence, the cash flows for Product A can be calculated as follows:

Initial cash outlay:

Building modifications	–$114,000
Equipment	–235,000
Total cash flow	–$349,000

	Years 1-14	Year 15
Revenue	$305,000	$305,000
Expenditures	180,000	180,000
Depreciation	23,267	23,267
Restoration cost	0	65,000
EBT	$101,733	$36,733
Tax	34,589	12,489
NI	$67,144	$24,244
OCF	$90,411	$47,511

The Operating Cash Flow (OCF) each year = net income plus depreciation. So, the NPV for modifying the building to manufacture Product A can be calculated as follows:

NPV = –$349,000 + $90,411(PVIFA_12%,14) + $47,511/1.12¹⁵

NPV = $258,937.13

Option C. : calculation of the NPV for the decision to modify the building to produce Product B

a. The income statement for this modification would remain same for the first 14 years.

b. In Year 15, the company would be incurring an additional expense to convert the building back to its original form. This will be an expense in Year 15, which will make changes in the income statement.

c. The cash flow at Year 0 would be the cost of the equipment, and the cost of the initial building modifications, both of which would be depreciated on a straight-line basis.

Hence, the cash flows for Product B can be calculated as follows:

Initial cash outlay:

Building modifications	–$132,000
Equipment	–282,000
Total cash flow	–$414,000

	Years 1-14	Year 15
Revenue	$372,000	$372,000
Expenditures	230,000	230,000
Depreciation	27,600	27,600
Restoration cost	0	78,000
EBT	$114,400	$36,400
Tax	38,896	12,376
NI	$75,504	$24,024
OCF	$103,104	$51,624

The Operating Cash Flow (OCF) each year = net income plus depreciation. Hence, the NPV for modifying the building to manufacture Product B can be calculated as follows:

NPV = –$414,000 + $103,104(PVIFA_12%,14) + $51,624/1.12¹⁵

NPV = $278,822.17

We could have also compared the above three options by analysing the incremental cash flows between Product A and continuing to rent the building, and the incremental cash flows between Product B and continuing to rent the building. We can see this calculation as below:

a. NPV of differential cash flows between Product A and continuing to rent:

NPV = NPV_{Product A} – NPV_Rent

NPV = $258,937.13 – 224,758.53

NPV = $37,178.60

b. NPV of differential cash flows between Product B and continuing to rent:

NPV = NPV_{Product B} – NPV_Rent

NPV = $278,822.17 – 224,758.53

NPV = $54,063.64

As we can see above, under Both the above incremental analyses have a positive NPV.

Since Product B has the highest marginal NPV, the company should select Product B as we have seen under both the above analysis calculations.