Red Rock Lobster (RRL) is looking to expand its business. The new business would generate $2.5 million per year in sales over the next 5 years. Annual costs would increase by Analysis $2.1 million. An investment in working capital of $50,000 would have to be made initially. The machinery (CCA rate of 30%) would cost $700,000, with additional costs of $10,000 and $20,000 to be incurred for setup and training. RRL estimates that it would be possible to sell the equipment for 10% of its initial value at the end of 5 years. The company would set up operations in a building it does not use but does rent out for $100,000 per year. If RRL’s cost of capital is 12% and its tax rate is 28%, should it proceed with this per year. If RRL’s cost of capital is 12% and its tax rate is 28%, should it proceed with this new business?
SOLUTION
The initial investment is $780,000:
| Equipment cost | $700,000 |
|---|---|
| Set up and training | 30,000 |
| Investment in NWC | 50,000 |
| Total | $780,000 |
The present value of the after-tax project cash flows is $779,000:
| (000s) | Year 1 | Year 2 | Year 3 | Year 4 | Year 5 |
|---|---|---|---|---|---|
| Sales | $2,500 | $2,500 | $2,500 | $2,500 | $2,500 |
| Less forgone rental income | 100 | 100 | 100 | 100 | 100 |
| Costs | 2,100 | 2,100 | 2,100 | 2,100 | 2,100 |
| Project cash flows before tax | 300 | 300 | 300 | 300 | 300 |
| Tax (28%) | 84 | 84 | 84 | 84 | 84 |
| Project cash flows after tax | $216 | $216 | $216 | $216 | $216 |
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