Question

A company is considering building a new and improved production facility for one of its existing

products. It would be built on a piece of vacant land that the firm owns. This land was acquired

four years ago at a cost of $500,000; it has a current market value of $800,000. The building can

be erected for $600,000. Machinery (equipment) worth $120,000 needs to be bought. The

company will finance the construction of the building and the purchase of the equipment by

borrowing $720,000 for 10 years at 10% interest. Interest will be paid annually and the full

amount of the loan will be repaid in one payment at the end of the 10 years. The company’s net

working capital will increase by $100,000 if the new production facility is built. Operating savings

from the new production facility are expected to be $300,000 per year for the next 10 years. The

total fair market value (salvage value) of the assets at the end of the 10 years is expected to be

$1,000,000− one quarter of which is attributable to the building and equipment. The building and

equipment will be amortized on a straight-line basis over 10 years. The firm’s tax rate is 40

percent and CCA will be taken on all depreciable assets at a rate of 20%. The firm’s weighted

average cost of capital (WACC) is estimated at 15 percent. Should the company build the new

and improved production facility? Round final dollar amounts (in each category) to closest

dollar (i.e., ignore cents).

[NOTE: Although not realistic, the question assumes that the construction of the building will be

completed “immediately”. Thus, the operating savings are realized starting Year 1.]

Answer 1

Yes, Company Should build the new and improved production Facility. Working and explanation are as under:

P.V. of WACC for 10 years is 5.0188 & at 15th year is 0.247.

The Cost of the company for Land, Eraction of Building & Set up of Machinary is as under:

Cost of Company
4 Yrs ago Cost Value	5,00,000
Building Eraction Cost	6,00,000
Machinary	1,20,000
Total Value:	12,20,000

P.V. of Interest for 15 years is:

10% Interest of 720,000 loan is 72,000

So, it comes to 72,000 multiplied with 5.0188 comes to 361,354.

Depreciation of Assets:

Cost of Building & Machinary is 720,000

Rate of Depreciation is 20%

Depreciation Value: 144,000

Present Value of Operating saving is: (300,000*5.0188) comes to 1,505,640.

Salvage Value of an assets at 10th year is: (1,000,000*0.247) comes to 247,000

So, the ultimate gain company can realise  by investing amount in Production facility is as under:

	Cost of the companyTotal Value:	1,220,000
Add:	P.V. of Int on Loan	361,354
	P.V. of Operating SAVINGS	1,505,640
	Salvage value of asset in 15th Year	247,000
Less:	Depre of Assets	144,000
	Increase of Net Working Capital	100,000
	Benefit received	3,089,994