A project that requires a firm to invest funds in additional assets in order to increase sales (or reduce costs) is called an asset expansion project. For example, suppose the TLC Yogurt Company has decided to capitalize on the exercise fad and plans to open an exercise facility in conjunction with its main yogurt and health foods store. To get the project under way, the company will rent additional space adjacent to its current store. The equipment required for the facility will cost $50,000.
Shipping and installation charges for the equipment are expected to total $5,000. This equipment will be depreciated on a straight-line basis over its 5-year economic life to an estimated salvage value of $0. In order to open the exercise facility, TLC estimates that it will have to add about $7,000 initially to its net working capital in the form of additional inventories of exercise supplies, cash, and accounts receivable for its exercise customers (less accounts payable).
During the first year of operations, TLC expects its total revenues (from yogurt sales and exercise services) to increase by $50,000 above the level that would have prevailed without the exercise facility addition. These incremental revenues are expected to grow to $60,000 in year 2, $75,000 in year 3, decline to $60,000 in year 4, and decline again to $45,000 during the fifth and final year of the project’s life. The company’s incremental operating costs associated with the exercise facility, including the rental of the facility, are expected to total $25,000 during the first year and increase at a rate of 6 percent per year over the 5-year project life.
Depreciation will be $11,000 per year ($55,000 installed cost, assuming no salvage value, divided by the 5-year economic life). TLC has a marginal tax rate of 40 percent. In addition, TLC expects that it will have to add about $5,000 per year to its net working capital in years 1, 2, and 3 and nothing in years 4 and 5. At the end of the project, the total accumulated net working capital required by the project will be recovered.
Calculating the Net Investment
First, we determine the net investment required for the exercise facility expansion. TLC must make a cash outlay of $50,000 to pay for the facility equipment. In addition, it must pay $5,000 in cash to cover the costs of shipping and installation of the equipment. Finally, TLC must invest $7,000 in initial net working capital to get the project under way. The 4-step procedure discussed earlier for calculating the net investment yields the NINV required at time 0:
Note that steps 3 and 4 are not required in this problem since this is an asset expansion decision and no existing assets are being sold.
Calculating Annual Net Cash Flows
Next, we need to calculate the annual net cash flows associated with the project. The first year net cash flows can be computed by substituting _R = $50,000, _O = $25,000, _Dep = $11,000, T = 0.40, and _NWC = $5,000 into Equation :
Year 1:NCF1 = ($50,000 – $25,000 – $11,000) (1 – 0.40) + $11,000 – $5,000 = $14,400
A similar calculation for the second year, where _R = $60,000, _O = $25,000 (1 + 0.06)1 = $26,500, _Dep = $11,000, T = 0.40, and _NWC = $5,000, yields:
Year 2:NCF2 = ($60,000 – $26,500 – $11,000) (1 – 0.40) + $11,000 – $5,000 = $19,500
Finally, in the fifth year, TLC will recover its working capital investment of $22,000, i.e., $7,000 (Year 0) and $5,000 (Years 1, 2, and 3). Substituting _NWC = –$22,000, along with _R = $45,000 and _O = $25,000 (1 + 0.06)4 = $31,562, _Dep = $11,000, and T = 0.40 into Equation yields:
Year 5NCF5 = ($45,000 – $31,562 – $11,000) (1 – 0.40) + $11,000 – (–$22,000) = $34,463
The calculations of annual cash flows for these years as well as for years 3 and 4 are summarized in Table Note that since the equipment was fully depreciated and had no salvage value at the end of the fifth year, the after-tax salvage value was $0. The cash flows associated with the exercise facility project are illustrated with the time line in Figure.
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