Question

Page 7 of 10 Question 2 Benson Enterprises is evaluating alternative uses for a threc-story manufacturing and warehousing building that it has purchased for $850,000. The company can continue to rent the building to the present occupants for $36,000 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 to use for it's owns 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; Product A Product B $65,000 $45,000 Initial cash Outlay for building modifications 205,000 165,000 Initial cash outlay for equipment 165,000 75,000 135,000 60,000 Annual pretax cash revenues (generated for 15 years) Annual pretax expenditures (generated for 15 years) The building will be used for only 15 years for either product A or product 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 has been undertaken is $29,000. If product B has been manufactured, the cash cost will be $35,000. These cash costs can be deducted for tax purposes in the year the expenditures occur. Benson will depreciate the original building shell (purchased for $850,000) over a 30-year life to zero, regardless of which alternative it chooses. The building modifications and equipment purchases for either product are estimated to have a 15- vear life. They will be depreciated by the straight-line method. The firm's tax rate is 34 percent, and its required rate of return on such investment is 12 percent. Required: For simplicity assume all cash flows occur at the end of the year. The initial outlay or modification and equipment will occur today (year 0), and the restoration outlays l occur at the end of year 15. Benson has other profitable ongoing operations that re sufficient to cover any losses. Which use of the building would you recommend to management? (25 marks) O The University of the West Indies Course Code: DITD 11

Answer 1

	Product A	Product B	Continue to rent
NPV of differential costs &revenues
Initial cash outlay for :
Building modifiction	-45000	-65000
Equipment	-165000	-205000
PV of after-tax net revenues
P/A,i=12%;n=15 yrs.,(135000-60000)*(1-34%)
49500*6.81086	337138
P/A,i=12%;n=15 yrs.,(165000-75000)*(1-34%)
59400*6.81086		404565
PV of Depn. Tax shields:
Building modifications
45000/15=3000*34%*6.81086	6947
65000/15=4333*34%*6.81086		10034
Equipment
165000/15=11000*34%*6.81086	25473
205000/15=13667*34%*6.81086		31649
PV of after-tax Restoration costs at end of yr.15:
29000*(1-34%)*0.18270	-3497
P/F,i=12%;n= Yr.15
35000*(1-34%)*0.18270		-4220
1.NPV of differential costs &revenues	156060	172027
2.PV of Depreciation tax shields on existing buildings available for the 15-yr.period
850000/30=28333*34%*6.81086	65611	65611	65611
(same for all options)
3.PV of after-tax rental income
36000*(1-34%)*6.81086			161826
Net NPV of comparative cash flows for both products(1+2+3)	221671	237638	227437
From the above workings, it is evident that Product B alternative, returns the highest NPV of $ 237638.
So, Product B alternative is RECOMMENDED.