Reference no: EM13918342
"Ocean Adventures Co." is located near a beautiful beach in Southern California and has been known for its surf board rentals for many years (this is a fictional company, by the way). The company's manager has been contemplating for a long time to, at least temporarily, shut the surf board business down and switch to something more unusual, even if risky.
The company's manager initially spent a month researching the potential of a new business idea. This cost him $5,000 about a year ago. In addition, he recently hired a group of local consultants, to whom he paid $20,000, to analyze the local market regarding the potential of a new project. Very soon the consultants came up with a recommendation to sell all surf boards and replace the surf board rental with a sailing catamaran rental business.
To start the new business, the company will need to purchase 60 brand new sailing catamarans at $10,000 per each. Unlike surf boards, catamarans are more durable and it takes 15 years for each to fully depreciate (under MACRS). "Ocean Adventures Co." is currently planning to keep the new business for 7 years, and to shut the project down and sell all catamarans at the end of the 7th year. Currently, used catamarans can be sold in the market for an average of $1,500 per machine, and due to the growing popularity of this sport the price for used catamarans is expected to rise at an annual rate of 10 percent.
"Ocean Adventures Co." currently owns 400 surf boards, half of which were purchased ten years ago for $1,000 a piece and the remaining half five years ago for the same price. Each could be sold today at the market price of $300 a piece. Each surf board's normal economic life is ten years and each board depreciates at a constant rate each year to a zero book value at the end of its life.
The company expects that each year it will be able to rent each sailing catamaran to 500 customers at the price of $20 per person per hour. It assumes that each person will ride a catamaran for exactly an hour at a time. The company is hoping that the business will become very popular among the locals and so the number of customers would be increasing by 100 people each year. Miscellaneous fixed costs are expected to equal $20,000 each year. The cost of maintaining each catamaran will cost the company $8 per each catamaran rental. In order to cover unforeseen repair expenses, the company would need to immediately set aside $5,000 in cash, and it would need to increase this amount by $500 each following year. At the end of the final year of the sailing catamaran project the money would be recovered as the cash buffer would no longer be needed.
The corporate tax rate is 34%.
The riskiness of this project requires an 8% annual rate of return.
Based on the information given above, answer the following questions:
1. Since the market price for used catamarans is rising by 10 percent each year, the company's manager is wondering whether delaying shutting the business down under the unsuccessful scenario by one year would be more profitable. What would be the value (in dollars) of the option to delay shutting the business down by one additional year (i.e, shutting down at the end of year 2 instead of at the end of year 1)? Would the delay be worth it? Explain and show all calculations.