Eightball Fabricating manufactures springs and related components for a variety of industrial and consumer end products. EF is evaluating a new business opportunity. In response to the growing health consciousness of the affluent aging baby boomer generation, a new concept in traction-associated exercise equipment is being developed. EF feels confident it can be a supplier of choice of the high quality springs needed for this new generation of equipment. Eightball Fabricating has determined that its existing manufacturing facilities are not suitable for the manufacture of the type of spring needed. Hence, in order to evaluate whether to enter this market, Eightball Fabricating needs to consider the return on investment in a new manufacturing facility. Eightball Fabricating has identified two options for its potential new manufacturing site:
Option A: Renovation of an existing warehouse (economic life of 10 years)
Option B: Construction of a completely new facility (economic life of 20 years)
Eightball Fabricating projects it will be able to sell
8,000 spring sets per year
for the foreseeable future. Price per spring set is $799 (in year end 1 dollars). EF has employed a nominal discount rate of
8.5 percent
on similar construction projects in the past. The following additional data have been collected. Assume all cash flows occur at the end of the year.
Inflation is 3 percent per year. Depreciation expense is calculated on a straight-line basis, with no salvage value.
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Option A
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Option B
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Construction costs*
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$3,200,000
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$10,000,000
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Annual operating costs**
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Fixed
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$1,000,000**
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$880,000**
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Variable
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$570/spring set
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$550/spring set
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The changes to the tax code enacted in 2017 alter the analytical structure some. The two most relevant changes are:
a. The lower tax rate. It is now 21%. This change is easy to reflect.
b. The ability to write off all the depreciation expense on a capital expenditure in year one of a project. This change can most easily be accommodated by showing depreciation of 100% of the capital expenditure in year 1 of the project. Then, depreciation expense for the remaining years of the project is 0%.
*Assume all construction costs are incurred in period 0.
**Assume all these operating costs are incremental and represent cash flows. These operating cost projections apply to the first year of operations. Cash costs (as well as revenues) are expected to increase with inflation. Inflartion app,ies initially in year 2.
Required: Prepare a financial analysis of the two options and make a recommendation. Use the income statement to net cash flow format, reflecting EBITDA, EBIT, EBIAT, and NCF.
Learning Points:
- Mutually exclusive projects with different economic lives
- Tax effects
- Depreciation as non-cash expense
- EBITDA and NCF
- Discount rate and inflation