Recycltoy Inc. is a company that produces recycled toys. The company is examining an investment in a new toy – recycled basketball. The CEO, who is against the project, hired you as a consultant to examine whether or not the company should undertake the project. The CEO promised you the following compensation for your work: (1) an assured payment of $100 thousand; (2) A bonus of $300 thousand if you are able to convince the board of directors not to undertake the project. Both payments (if paid) will be paid today.
According to your estimation, the expense for research and development of the recycled basketball will take one year and will cost $4.5 million (today). After finishing product development (the recycled basketball).
In addition, you know the following:
- The company expects revenues of $500 thousand for the first operating year. Due to new enacted regulation from the government, which supports the use of recycled products, in the next three years the company estimates that the revenues will increase by 30% each year. thereafter, it expects that the revenues will increase by 2% in perpetuity (assume that from this period (year 5) the CASH FLOWS are increasing by 2% forever).
- In order to start the operation, the company will need to invest $900 thousand in equipment. The investment will be depreciated over 3 years with no salvage value. The equipment will operate forever (you will not need to replace it).
- The company owns a warehouse in which it wants to locate the recycled basketball activity (it needs it today). Currently. The company rents out the warehouse for $50 thousand per year. The tenant has a contract for 4 years which can be canceled for a one-time payment of $100 thousand (today). Additionally, the company informed you that, due to change in the municipal regulations, in 4 years, the company will not be able to rent out the warehouse.
- The company estimates that the operating costs will be 25% of the revenues.
- The company has other profitable projects.
- The cost of capital for this project is 10%.
- The corporate tax rate is 25%, while the capital gain tax is 20%.
- Unless stated otherwise, all cash flows occur at the end of each year.
What is your recommendation, should they undertake the project? (show calculations)