Inflation and Its Impact on Project Cash Flows
at the end of five years. The milling machine will have a $10,000 salvage value at the end of its life, and the special jigs and dies are worth only $300 as scrap metal at any time in their lives. The machine is classified as a seven year MACRS property, and the special jigs and dies are classified as a three year MACRS property. With the new milling ma chine, Wilson expects an additional annual revenue of $80,000 due to increased production. The addi tional annual production costs are estimated as fol lows: materials, $9,000; labor, $15,000; energy, $4,500; and miscellaneous O&M costs, $3,000. Wilson’s marginal income tax rate is expected to remain at 35% over the project life of 10 years. All dollar figures represent today’s dollars. The firm’s market interest rate is 18%, and the expected gen eral inflation rate during the project period is esti mated at 6%. (a) Determine the project cash flows in the absence of inflation. (b) Determine the internal rate of return for the pro ject in part (a). (c) Suppose that Wilson expects price increases during the project period: material at 4% per year, labor at 5% per year, and energy and other O&M costs at 3% per year. To compen sate for these increases in prices, Wilson is planning to increase annual revenue at the rate of 7% per year by charging its customers a higher price. No changes in salvage value are expected for the machine or the jigs and dies. Determine the project cash flows in actual dollars. (d) In part (c), determine the real (inflation free) rate of return of the project. (e) Determine the economic loss (or gain) in pre sent worth caused by inflation. ST11.3 Recent biotechnological research has made possible the development of a sensing device that implants living cells on a silicon chip. The chip is capable of detecting physical and chemical changes in cell processes. Proposed uses of the device in clude researching the mechanisms of disease on a cellular level, developing new therapeutic drugs, and substituting for animals in cosmetic and drug test ing. Biotech Device Corporation (BDC) has just perfected a process for mass producing the chip.
The following information has been compiled for the board of directors: • BDC’s marketing department plans to target sales of the device to the larger chemical and drug manufacturers. BDC estimates that annual sales would be 2,000 units if the device were priced at $95,000 per unit (in dollars of the first operating year). • To support this level of sales volume, BDC would need a new manufacturing plant. Once the “go” decision is made, this plant could be built and made ready for production within one year. BDC would need a 30 acre tract of land that would cost $1.5 million. If the decision were to be made, the land could be purchased on Decem ber 31, 2009. The building would cost $5 million and would be depreciated according to the MACRS 39 year class. The first payment of $1 million would be due to the contractor on De cember 31, 2010, and the remaining $4 million on December 31, 2011. • The required manufacturing equipment would be installed late in 2011 and would be paid for on December 31, 2011. BDC would have to pur chase the equipment at an estimated cost of $8 million, including transportation, plus a fur ther $500,000 for installation. The equipment would fall into the MACRS seven year class. • The project would require an initial investment of $1 million in working capital. This investment would be made on December 31, 2011. Then on December 31st of each subsequent year, net working capital would be increased by an amount equal to 15% of any sales increase expected dur ing the coming year. The investments in working capital would be fully recovered at the end of the project year. • The project’s estimated economic life is six years (excluding the two year construction period). At that time, the land is expected to have a market value of $2 million, the building a value of $3 million, and the equipthent a value of $1.5 mil lion. The estimated variable manufacturing costs would total 60% of the dollar sales. Fixed costs, excluding depreciation, would be $5 million for the first year of operations. Since the plant would begin operations on January 1, 2012, the first op erating cash flows would occur on December 31, 2012.
Attachments:
assignment 6….pdf