RWE Enterprises. Inc. (RWE) is a small manufacturing firm located in the hills just outside Adelaide, South Australia. The firm is engaged in the manufacturing and sale of feed supplements used by cattle raisers. The product has a molasses base but is supplemented with minerals and vitamins that are generally thought to be essential for the health and growth of beef cattle. The final product is put in 50-kg or 90-kg tubs that are then made available for the cattle to lick as desired. The material in the tub becomes very hard, which limits the animals consumption.
The firm has been running a single production line for the last 5 years and is considering the addition of a new line. The addition would expand the firm's capacity by almost 120% since the new equipment requires a shorter down time between batches. After each production run, the boiler used to prepare the molasses for the additions of minerals and vitamins must be heated to 85oC and then must be cooled down before starting the next batch. The total production run entails about 4 hours and the cool down period is two hours (during which time the whole process comes to a halt). Using 2 production lines will increase the overall efficiency of the operation since workers from the line that is cooling down could be moved to the other line to support the 'canning' process involved in filling the feed tubs.
The second production line equipment would cost $3 million to purchase and install and would have an estimated life of 10 years at which time it could be sold for an estimated after tax scrap value of $200,000. Furthermore, at the end of five years the production line would have to be refurbished at an estimated cost of $2 million. RWE's management estimates that the new production line would add $700,000 per year after-tax cash flow to the firm. The 10-year cash flows for the line are as follows:
|
YEAR
|
CASH FLOW
|
|
0
|
-$3,000,000
|
|
1
|
700,000
|
|
2
|
700,000
|
|
3
|
700,000
|
|
4
|
700,000
|
|
5
|
-1,300,000
|
|
6
|
700,000
|
|
7
|
700,000
|
|
8
|
700,000
|
|
9
|
700,000
|
|
10
|
900,000
|
Part (a) If RWE uses a 10% discount rate to evaluate investments of type, what is the net present value of the project? What does the NPV indicate about the potential value RWE might create by purchasing the new production line?
Required answers showing all calulations where required
a) Complete part (a) only for the Case Study in chapter 11 of the textbook.
Assume that RWE in this Case Study is a company with its entire shareholding resident in the United Kingdom and Singapore where the company, although not listed on a public stock exchange, has an active secondary market for its shares.
(As a guide students should write no more than 125 words for this part of the question).
b) Given the information provided in this question, including the further details provided above, why are after-tax cash flows most relevant in this capital budgeting exercise for RWE?
(As a guide students should write no more than 50 words for this part of the question).
c) Supplement your response of what the calculated NPV indicates in part a) of this question with a brief reference as to how your discussion of "potential value" as indicated in part a) could benefit from knowing the equity structure of RWE. That is, if you knew the equity structure of RWE, how could you provide shareholders with further useful information regarding the consequences of accepting / rejecting the proposed project? This discussion should include a brief reference to the issue as to when the "potential value", if any, would arise for shareholders in RWE.