Question

Choice 2: Capital Budgeting Decision Since LSUS corporation is producing at full capacity, Amanda has decided to have Han examine the feasibility of a new manufacturing plant. This expansion would represent a major capital outlay for the company. A preliminary analysis of the project has been conducted at a cost of $1.6 million. This analysis determined that the new plant will require an immediate outlay of $54 million and an additional outlay of $31 million in one year. The company has received a special tax dispensation that will allow the building and equipment to be depreciated on a 20-year MACRS schedule. For Property Placed in Service after December 31, 1986 Recovery 3-Year 5-Year 7-Year 10-Year Year (200% DB) (200% DB) (200% DB) (200% DB) 20-Year (150% DB) 33.33 4445 1481 20.00 32.00 19.20 11.52 11.52 5.76 14.29 24.49 1749 1240 10.00 18.00 14.40 11.52 9.22 7.37 6.55 6.55 15-Year (150% DB) 5.00 9.50 8.55 7.70 6.93 6.23 5.90" 5.90 5.91 5.90 5.91 5.90 5.91 656 3.750 7.219 6.677 6.172 5.713 5.285 4.BBB 4.522 4.462 4.461 4.462 4.461 4.462 4.461 4.462 4.461 4.462 4.461 4.462 4.461 2.231 5.90 5.91 2.95 Switchover to straight-line depreciation Because of the time necessary to build the new plant, no sales will be possible for the next year. Two years from now, the company will have partial-year sales of $17 million. Sales in the following four years will be $28 million, $37 million, $40 million, and $43 million. Because the new plant will be more efficient than LSUS corporation's current manufacturing facilities, variable costs are expected to be 65 percent of sales, and fixed costs will be $2.4 million per year. The new plant will also require net working capital amounting to 8 percent of sales for the next year. Han realizes that sales from the new plant will continue into the indefinite future. Because of this, he believes the cash flows after Year 5 will continue to grow at 2.5 percent indefinitely. The company's tax rate is 40 percent and the required return is 12 percent.

3) After the examine the three approaches, Amanda would like Han to analyze the financial viability of the new plant and calculate the profitability index, NPV, and IRR.

Answer 1

Calculation of discounted cash inflows

	Year 1	Year 2	Year 3	Year 4	Year 5	Year 6	Year 7	Year 8
Sales	17	28	37	40	43	44	45	46
Less Variable cost	11.05	18.2	24.05	26	27.95	28.6	29.25	29.9
Less Fixed cost	2.4	2.4	2.4	2.4	2.4	2.4	2.4	2.4
Net cash inflow	3.55	7.4	10.55	11.6	12.65	13.02	13.41	13.81
PVIF @12%	0.893	0.797	0.712	0.636	0.567
Discounted cash inflow	3.17	5.89	7.51	7.38	7.17

Total Discounted cash inflows=3.17+5.89+7.51+7.38+7.17=31.12 m

Calculation of Profitability Index

Profitability index =Sum of discounted cash inflows /Total discounted cash outflow

=31.12/54+(31*.893)

=31.12/54+27.68

=31.12/81.68

=0.38

Calculation of NPV=Discounted cash infloes -initial cash outflows

=31.12-8.68= -50.56 million

Therefore NPV is negative

Calculation of IRR

Since cash inflows from project are not equal we have to calculate IRR By trial and error method

PVIF @2%

Year	Cash Inflow	r=2%	PVIF @2%	r= 5%	PVIF 5%
1	3.55	0.980	3.48	0.952	3.38
2	7.4	0.961	7.11	0.907	6.71
3	10.55	0.942	9.94	0.863	9.10
4	11.6	0.924	10.72	0.822	9.53
5	12.65	0.906	11.46	0.783	9.90
6	13.02	0.888	11.56	0.746	9.71
7	13.41	0.870	11.67	0.710	9.52
8	13.81	0.853	11.78	0.676	9.39
total		0.837	11.89	0.645	9.16
			89.61		76.4

The IRR is more than 2 % but less than 5%

IRR=[2+(89.61-85/89.61-76.40*3)]

IRR=3.05%