Question

Smith Electronics Ltd. (Smith) manufactures portable CD and DVD players for a well-known international distributer. As the chief financial officer for Smith, you are currently evaluating a major expansion plan. While the plan itself is likely to have a much longer term impact on the firm’s profitability, Smith has always taken a relatively risk-averse view to capital expenditures and has used a four-year planning horizon, which it will do again in this instance.

The project will require an investment of $5 million for a new building and $2.5 million for new equipment. The expected useful lives of the building and the equipment are 25 years and four years, respectively. The company recently purchased a block of land at a cost of $800,000 to build on if it decides to go ahead with the plan. An independent appraiser has indicated that the value of the land currently remains unchanged from its original purchase price but it should be worth approximately $1.25 million in four years based on current real estate trends. At the end of the four-year planning horizon, the building is expected to be worth 80% of its original cost and the equipment worth 40% of its original cost. However, the company believes that it may have other uses for the building at the end of the project and may retain it throughout its useful life, at the end of which it is expected to have zero salvage value. Both the building and equipment will be depreciated on a straight-line basis. Finally, to support the expansion plan, an additional investment in net working capital of $500,000 will also be required.

To help with the analysis, the controller’s office has provided the following projected income statements for the project (all figures in 000’s):

Year 1             Year 2             Year 3             Year 4

Revenues                                 $ 10,500          $ 11,000          $ 12,500          $ 13,500

Cost of goods sold                       7,500               7,800               8,500               8,800

Amortization                                   575                 575                  575                  575

Interest expense                              300                  300                  300                  300

Tax expense                                    744                  814               1,094               1,339

Net income                                   1,381            $ 1,511            $ 2,031            $ 2,486

Finally, Smith’s marginal tax rate is 35% and its weighted-average cost of capital is 10%. The applicable CCA rates on the new building and the new equipment are 5% and 25%, respectively.

Question: with all calculations shown

Based on the net present value (NPV) method, determine whether Smith should undertake the proposed expansion plan.

Answer 1