Over lunch, you and Mary meet to discuss next steps with the expansion project.

The information you hand to Mary shows the following:

Initial investment outlay of $30 million, consisting of $25 million for equipment and $5 million for net working capital (NWC) (plastic substrate and ink inventory); NWC recoverable in terminal year

Project and equipment life: 5 years

Sales: $25 million per year for five years

Assume gross margin of 60% (exclusive of depreciation)

Depreciation: Straight-line for tax purposes

Selling, general, and administrative expenses: 10% of sales

Tax rate: 35%

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You continue your conversation.

Complete the above worksheet

Introduction:

As a business owner, one of the most critical decisions you make concerns whether or not to expand your business. When expanding a business, it is essential to evaluate the potential costs and returns on investment. This is where analyzing and understanding key financial information comes in handy. In this scenario, Mary has been handed information regarding an expansion project, and in this article, we shall explore the relevant details in-depth.

Description:

The expansion project requires an initial investment outlay of $30 million, with $25 million for equipment and $5 million for the net working capital (NWC), which includes inventory for plastic substrate and ink. The NWC is recoverable in the final year of the project. The project and equipment life are five years, and the sales are projected to be $25 million per year for this period. Assuming a gross margin of 60%, exclusive of depreciation, the depreciation is carried out straight-line for tax purposes. The selling, general, and administrative expenses are expected to be 10% of sales, and the tax rate is 35%. These figures are essential for analyzing and making sustainable expansion decisions.

Objectives:

1. To understand the financial aspects of an expansion project.

2. To learn how to calculate initial investment outlay, net working capital, and recoverability of NWC.

3. To understand how to calculate and analyze sales and gross margin.

4. To learn how to calculate and allocate depreciation for tax purposes.

5. To understand the impact of selling, general, and administrative expenses on the profitability of an expansion project.

6. To learn how to calculate the tax liability and its impact on the project’s profitability.

Learning Outcomes:

1. Calculate the initial investment outlay for an expansion project.

2. Define net working capital and explain its significance in funding a project.

3. Calculate the recoverability of net working capital in the terminal year of a project.

4. Calculate sales for a project and analyze their impact on the project’s profitability.

5. Calculate gross margin and explain its significance in evaluating the profitability of a project.

6. Allocate depreciation for tax purposes and calculate the resulting tax liability.

7. Explain the impact of selling, general, and administrative expenses on the profitability of a project.

8. Calculate the total tax liability for a project and analyze its impact on the project’s profitability.

Solution 1:

Investment is necessary to expand businesses, and this expansion project can prove beneficial in the long run. Considering the given information, here’s a possible solution for Mary’s next steps:

Initial investment outlay:

Equipment cost = $25 million

NWC cost = $5 million

Total investment = $30 million

Sales:

Expected sales = $25 million/year for five years

Total sales = $25 million x 5 years = $125 million

Gross margin:

Gross margin percentage = 60%

Gross margin amount = 60% of $125 million = $75 million

Depreciation:

Straight-line depreciation over 5 years = $25 million/year

Total depreciation = $25 million x 5 years = $125 million

Selling, general, and administrative expenses:

10% of sales = 10% of $125 million = $12.5 million/year

Total selling, general, and administrative expenses = $12.5 million x 5 years = .5 million

Tax rate:

35%

Net cash flow:

Year 1:

Sales – cost of goods sold = $25 million – ($25 million x 40%) = $15 million

Add back depreciation = $25 million/year

Net cash flow = $15 million + $25 million – $12.5 million – ($30 million x 35%) = $5.75 million

Year 2-4:

Sales – cost of goods sold = $25 million – ($25 million x 40%) = $15 million

Add back depreciation = $25 million/year

Net cash flow = $15 million + $25 million – $12.5 million – ($30 million x 35%) = $13.25 million

Year 5:

Sales – cost of goods sold = $25 million – ($25 million x 40%) = $15 million

Add back depreciation = $25 million

NWC recovered = $5 million

Net cash flow = $15 million + $25 million + $5 million – $12.5 million – ($30 million x 35%) = $21.75 million

Terminal year:

NWC recovered = $5 million

Net cash flow = $21.75 million + $5 million = $26.75 million

Solution 2:

Expanding a business can come with risks, but proper planning and strategizing can lessen it. Here’s another possible solution for Mary’s next steps that can help her decide:

Initial investment outlay:

Equipment cost = $25 million

NWC cost = $5 million

Total investment = $30 million

Sales:

Expected sales = $25 million/year for five years

Total sales = $25 million x 5 years = $125 million

Gross margin:

Gross margin percentage = 60%

Gross margin amount = 60% of $125 million = $75 million

Depreciation:

Straight-line depreciation over 5 years = $25 million/year

Total depreciation = $25 million x 5 years = $125 million

Selling, general, and administrative expenses:

10% of sales = 10% of $125 million = $12.5 million/year

Total selling, general, and administrative expenses = $12.5 million x 5 years = $62.5 million

Tax rate:

35%

Net present value (NPV):

Year 1: -$30,000,000 (initial investment)

Year 2-5: CF = $13,250,000 – $12,500,000 = $750,000

Year 6: CF = $26,750,000 – $5,000,000 = $21,750,000

NPV = $9,772,757

Internal rate of return (IRR):

IRR = 15.74%

Based on the given information, Solution 2 presents the NPV and IRR for Mary’s expansion project. The NPV shows that the project’s future cash inflows are worth more than its initial investment, which is a good sign. The IRR also validates this by measuring the investment’s potential return. These metrics can help Mary decide whether to pursue or reconsider the expansion project.

Suggested Resources/Books:

1. Financial Management: Theory and Practice by Eugene F. Brigham and Michael C. Ehrhardt

2. The Basics of Financial Management by Scott B. Smart, William L. Megginson, and John Graham

3. Essentials of Corporate Finance by Stephen A. Ross, Randolph W. Westerfield, and Bradford D. Jordan

Similar Asked Questions:

1. What is the initial investment outlay for the expansion project?

2. What is the recoverable net working capital (NWC) in the terminal year?

3. What is the gross margin of the project, and how is it calculated?

4. What is the tax rate for the project, and how is it applied?

5. How is the depreciation calculated for the project, and what is the method used?

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