ABC Holdings are looking at a new manufacturing project

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?