Reference no: EM133005740

Question - Knack Inc. (Knack) is considering expanding its operations by adding a new product line. This project would have a 10-year time horizon, after which the product line would be discontinued.

The project would require new production equipment costing $6.5 million. This production equipment would have a useful life of 10 years and NO salvage value. The capital cost allowance (CCA) rate on the equipment would be 20% and is eligible for the accelerated investment incentive rules (ACII) for capital cost allowance (CCA).

A building would need to be constructed at a cost of $15 million. The building would have a $3 million salvage value at the end of its useful life of 45 years. At the end of the project, the building would have a salvage value of $9 million. The capital cost allowance (CCA) rate for the building would be 3% and is eligible for the accelerated investment incentive rules (ACII) for CCA.

The building would be constructed on a vacant piece of land that Knack purchased several years ago for $3 million. The land has a current market value of $4.5 million and is expected to have a market value of $7.9 million at the end of the project.

Changes in net working capital investments are forecast as follows:

Inventory: Increase in average balance of $2 million.

Accounts receivable: Increase in average balance of $1.5 million.

Accounts payable: Increase in average balance of $800,000.

Sales are expected to be $24 million each year of the project. Knack's cost of goods sold is estimated to be 60% of sales, operating expenses (excluding depreciation) are estimated to be 5% of sales, and depreciation is estimated to be 3% of sales each year.

In addition, Knack incurred $1.2 million of expenses for a marketing study specifically to determine whether the new product would appeal to potential customers. The marketing study showed an overwhelmingly positive response from customers. Knack's WACC is 7% and its effective tax rate is 37%.

Required - What is the net present value analysis of Knack's project, recommend whether Knack should accept or reject the project and provide the reason for your recommendation.