Question 1: Benson Enterprises is evaluating alternative uses for a three-story manufacturing and warehousing building that it has purchased for $225,000. The company can continue to rent the building to the present occupants for $12,000 per year. The present occupants have indicated an interest in staying in the building for at least another 15 years. Alternatively, the company could modify the existing structure to use for its own manufacturing and warehousing needs. Benson's production engineer feels the building could be adapted to handle one of two new product lines. The cost and revenue data for the two product alternatives are as follows:
Product A Product B
Initial cash outlay for building modifications $ 36,000 $ 54,000
Initial cash outlay for equipment 144,000 162,000
Annual pretax cash revenues (generated for 15 years) 105,000 127,500
Annual pretax expenditures (generated for 15 years) 60,000 75,000
The building will be used for only 15 years for either Product A or Product B. After 15 years, the building will be too small for efficient production of either product line. At that time, Benson plans to rent the building to firms similar to the current occupants. To rent the building again, Benson will need to restore the building to its present layout. The estimated cash cost of restoring the building if Product A has been undertaken is $3,750. If Product B has been manufactured, the cash cost will be $28,125. These cash costs can be deducted for tax purposes in the year the expenditures occur.
Benson will depreciate the original building shell (purchased for $225,000) over a 30-year life to zero, regardless of which alternative it chooses. The building modifications and equipment purchases for either product are estimated to have a 15-year life. They will be depreciated by the straight-line method. The firm's tax rate is 34 percent, and its required rate of return on such investments is 12 percent.
For simplicity, assume all cash flows occur at the end of the year. The initial outlays for modifications and equipment will occur today (year 0), and the restoration outlays will occur at the end of year 15. Benson has other profitable ongoing operations that are sufficient to cover any losses. Which use of the building would you recommend to management?
Question 2: The manager for a growing firm is considering the launch of a new product. If the product goes directly to market, there is a 50 percent chance of success. For $120,000, the manager can conduct a focus group that will increase the product's chance of success to 70 percent. Alternatively, the manager has the option to pay a consulting firm $400,000 to research the market and refine the product. The consulting firm successfully launches new products 90 percent of the time. If the firm successfully launches the product, the payoff will be $1.2 million. If the product is a failure, the firm will receive $0. Which action will result in the highest expected payoff to the firm?
Question 3: B&B has a new baby powder ready to market. If the firm goes directly to the market with the product, there is only 55 percent chance of success. However, the firm can conduct customer segment research, which will take a year and cost $1 million. By going through research, B&B will be able to better target potential customers and will increase the probability of success to 70 percent. If successful, the baby powder will bring a present value profit (at time of initial selling) of $30 million. If unsuccessful, the present value payoff is only $3 million. Should the firm conduct customer segment research or go directly to market? The appropriate discount rate is 15 percent.