ABC Holdings are looking at a new manufacturing project with a life of five years. The project has a non-depreciable capital requirement (e.g. land) of $350,000, which is expected to maintain its value in real terms (i.e. to increase in value with inflation). Real gains are subject to capital gains tax at the marginal rate. New machinery costing $400,000 including freight and installation is needed. Salvage value is expected to be $50,000 at the end of year 5. Tax depreciation is straight line over 4 years. The company plans to borrow the $400,000 for machinery from its bank at an interest rate of 8% per annum. It will use retained earnings to fund the purchase of the land although to afford this it will reduce its dividend payments by $70,000 per year for the five years. EBITDA from operations are expected to be (assume end of year):
Year 1 $250,000
Year 2 $300,000
Year 3 $380,000
Year 4 $300,000
Year 5 $240,000
Working capital requirements are 10% of EBITDA. Working capital is assumed to be needed, at the start of the year. To promote the new product the company will spend $53,000 (not included in the above values) on direct marketing in the first year.
The company's effective tax rate is expected to be 40% over the life of the project. For simplicity let us assume that tax is paid at the end of the year in which the cash flows occur. Expected inflation rate over the next five years is 6% and the company's cost of capital is 15%. Should the company undertake the new project?