Question

Hardwick Enterprises is evaluating alternative uses for a three-story manufacturing and warehousing building that it has purchased for $1,650,000. The company can continue to rent the building to the present occupants for $67,000 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 its own manufacturing and warehousing needs. The company’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
Initial cash outlay for building modifications	$	123,000	$	180,000
Initial cash outlay for equipment		350,000		363,000
Annual pretax cash revenues (generated for 15 years)		289,000		301,300
Annual pretax expenditures (generated for 15 years)		135,000		136,000

  

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, the company plans to rent the building to firms similar to the current occupants. To rent the building again, the company will need to restore the building to its present layout. The estimated cash cost of restoring the building if Product A has been undertaken is $95,000. If Product B has been manufactured, the cash cost will be $105,000. These cash costs can be deducted for tax purposes in the year the expenditures occur.

  

The company will depreciate the original building shell 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-year life. They will be depreciated by the straight-line method. The firm’s tax rate is 25 percent and the required rate of return on each alternative is 12 percent.

  

Assume all cash flows occur at the end of the year. The initial outlays for modifications and equipment will occur today, and the restoration outlays will occur at the end of Year 15.

  

Alternative 1:

What is the value of NPV of the decision to continue to rent? (Do not round intermediate calculations and round your answer to 2 decimal places, e.g., 32.16.)

Alternative 2:

What is the value of NPV for modifying the building to manufacture Product A? (Do not round intermediate calculations and round your answer to 2 decimal places, e.g., 32.16.)

Alternative 3:

What is the value of NPV for modifying the building to manufacture Product B? (Do not round intermediate calculations and round your answer to 2 decimal places, e.g., 32.16.)

Answer 1

Building shell depreciation
Purchase cost	1,650,000.0000
No. of years	30.0000
Depreciation per year	55,000.0000
Alternative 1 : Renting option
Year	1-15
Rental income	67,000.0000
Depreciation	(55,000.0000)
Before tax income	12,000.0000
Tax @ 25%	(3,000.0000)
After tax income	9,000.0000
Add : Depreciation	55,000.0000
Cashflows	64,000.0000
PV factor @ 12%	6.8109
PV of cashflows	435,895.3273

Building purchase cost of $ 1,650,000 cannot be considered as a cashflow here as it is already incurred (sunk cost). Hence it would not impact the decision making.

Alternative 2: Product A NPV					Alternative 3: Product B NPV
Modification cost and Equipment cost depreciation				Modification cost and Equipment cost depreciation
Building cost	123,000.0000				Building cost	180,000.0000
Equipment cost	350,000.0000				Equipment cost	363,000.0000
Total cost	473,000.0000				Total cost	543,000.0000
Useful life	15 years				Useful life	15 years
Depreciation (straight line method)	31,533.3333				Depreciation (straight line method)	36,200.0000
Alternative 1 : Producing Product A		Alternative 1 : Producing Product A
Year	0	1-14	15		Year	0	1-14	15
Initial cashflows		Initial cashflows
Building modifications	(123,000.0000)				Building modifications	(180,000.0000)
Equipment cost	(350,000.0000)				Equipment cost	(363,000.0000)
Total Initial cashflows	(473,000.0000)				Total Initial cashflows	(543,000.0000)
Operational cashflows		Operational cashflows
Annual cash revenue		289,000.0000	289,000.0000		Annual cash revenue		301,300.0000	301,300.0000
Annual expenditures		(135,000.0000)	(135,000.0000)		Annual expenditures		(136,000.0000)	(136,000.0000)
Restoration cost		-	(95,000.0000)		Restoration cost		-	(105,000.0000)
Building depreciation		(55,000.0000)	(55,000.0000)		Building depreciation		(55,000.0000)	(55,000.0000)
Depreciation : modification & equipment		(31,533.3333)	(31,533.3333)		Depreciation : modification & equipment		(36,200.0000)	(36,200.0000)
Before tax income		67,466.6667	(27,533.3333)		Before tax income		74,100.0000	(30,900.0000)
Tax @ 25%		(16,866.6667)	6,883.3333		Tax @ 25%		(18,525.0000)	7,725.0000
After tax income		50,600.0000	(20,650.0000)		After tax income		55,575.0000	(23,175.0000)
Add: Building Depreciation		55,000.0000	55,000.0000		Add: Building Depreciation		55,000.0000	55,000.0000
Add: Modification & Equip. depn.		31,533.3333	31,533.3333		Add: Modification & Equip. depn.		36,200.0000	36,200.0000
Operating cashflows		137,133.3333	65,883.3333		Operating cashflows		146,775.0000	68,025.0000
Total Cashflows	(473,000.0000)	137,133.3333	65,883.3333		Total Cashflows	(543,000.0000)	146,775.0000	68,025.0000
PV factor @ 12%	1.0000	6.6282	0.1827		PV factor @ 12%	1.0000	6.6282	0.1827
PV cashflows	(473,000.0000)	908,942.8030	12,036.6387		PV cashflows	(543,000.0000)	972,849.3917	12,427.9132
NPV	447,979.44		NPV	442,277.30