Question

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.

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.

4) After the empirical results, Han would like to provide the recommendation to Amanda and Board of directors, what is Han’s recommendation? Amanda also wants Han to 5 provide a sensitivity analysis and change any one of elements documented before and see what happens? For example, increase or decrease growth rate and at what level the firm can break even when NPV=0.

Answer 1

The Detailed analysis is provided in the Excel sheet below. As per the cash flow projection,

the NPV of the project is : -ve $ 37.14 mn, hence not recommendable

Sensitivity of Growth rate on the NPV of the project

		NPV
	2.50%	-37.14
Growth Rate	7.50%	-2.5
	10.00%	79.78

The NPV become zero when perpertuity growth rate is assumed to be 7.67%