Virtual Printing Inc. has devised a new technology based on which it plans to launch a new line of print media products. The firm intends to spend $160,000 in new plant and equipment and $40,000 in expanding its building facilities to house the project. The project has an estimated economic life of eight years. Assume, for tax purposes, that the machinery and equipment and building will be depreciated straight-line over its economic life.
In the first year of operation, Virtual Printing expects to generate sales revenues of $60,000. These revenues are expected to stay at the same level until year 3, but they are subsequently expected to grow by 10% annually until year 6, after which the revenues are expected to decline by 5% per year. First-year operating costs will be $15,000; in subsequent years, these are expected to grow in proportion to sales revenues. The tax rate applicable to Virtual Printing’s business will be 34%. Also, at the end of the project’s economic life, the plant and equipment will not have any salvage value. The expanded building facilities also cannot be sold, leased, or rented to another business entity without compromising the firm ‘s existing operations. Virtual Printing’s cost of capital is 12%.
a. Should Virtual Printing’s finance manager recommend accepting the project if the firm’s objective is to accept projects only when they are worth more than their cost?
b. Explain your answer to part (a) above. What technique did you use in that answer?
c. By what time frame can Virtual Printing expect to recover its initial investment in the project: (1) ignoring the time value of money and (2) taking into account the time value of money? Name the techniques you have used for your computation. What are the benefits and drawbacks to these techniques?
d. What is the IRR for this project?
e. Now, assume that for CCA purposes the plant and equipment actually belong to Class 39 and the buildings belong to Class 1, with applicable CCA rates of 25% and 4%, respectively. Recompute the project’s net present value, assuming that Virtual Printing has other assets in both asset classes that will be continued even after the economic life of this project is over. Work out your calculations assuming a zero salvage value for the building expansion and a $10,000 salvage value for the plant and equipment, at the end of the project’s economic life. Would you pursue the project under these new conditions? Explain your answer.