Question

Walker Industrial is planning to undertake a second line of business. With the new line of business, the firm will need to pay for an expansion of its distribution system earlier than it had initially planned. The current cost of the expanding the capacity of its distribution system is $1,000,000 and this cost is expected to increase by 3 percent per year. Undertaking the new line of business will force the company to pay for the expansion in only 3 years instead of in 6 years for which it had initially planned. Given a cost of capital of 8%, what is the net cost (in present value terms) for the early expansion that should be included in the capital budgeting analysis of the proposal for moving into the new line of business?

Answer 1

g = growth rate = 3%

r = cost of capital = 8%

Present Value of expansion in 3 years = Cost of Expansion * (1+g)^3 / (1+r)^3

= $1,000,000 * (1+3%)^3 / (1+8%)^3

= $1,000,000 * 1.092727 / 1.259712

= $867,441.9232

Present Value of expansion in 6 years = Cost of Expansion * (1+g)^6 / (1+r)^6

= $1,000,000 * (1+3%)^6 / (1+8%)^6

= $1,000,000 * 1.194052297 / 1.586874323

= $752,455.4902

Net Cost of Early expansion = Present Value of expansion in 3 years - Present Value of expansion in 6 years

= $867,441.9232 - $752,455.4902

= $114,986.433

Therefore, net cost of early expansion is $114,986.43