Reference no: EM133157666

Question - Edward is considering starting a business. The processing equipment costs are estimated at $245,000 and the building at $100,000. He estimates his working capital needs at $20,000. Edward thinks that he would like to run the business for 10 years and then do something else. Here are the details of his operating costs:

1. He estimates the revenue for the first year will be $220,000 with an increase of 5% per year for the 10-year project life.

2. Returns on products by customers are estimated at 7% of revenues for all years.

3. Cost of goods sold (COGS), which is the total of all operating expenses to make the product, are estimated as 35% of the revenues.

4. Edward believes that the business will be started in the month of January and can be sold at the end of 10 years.

a. The equipment will be depreciated on a MACRS basis as a seven-year property.

b. The building will be depreciated as real property.

c. Assume the business will start in the January and sold in December.

d. Working capital will be recovered as part of the price that Edward will get for the business.

5. Edward estimates his selling and administrative expenses:

a. Selling expenses will be 10% of revenue in Year 1, increasing by 0.1% every year. This means that the Year 2 selling expenses will be 10.1% of that year's revenue, the Year 3 selling expenses will be 10.2% of that year's revenue, and so on.

b. Administrative expenses will be 2% of revenue in Year 1, increasing by 0.5% every year. This means that the Year 2 administrative expenses will be 2.5% of that year's revenue, the Year 3 selling expenses will be 3.0% of that year's revenue, and so on.

c. Research expenses will be $24,000 in the first year and will increase by 5% every year. d. Marketing expenses will be 5% of revenue in Year 1, increasing by 0.5% every year. This means that Year 2 marketing expenses will be 5.5% of that year's revenue, Year 3 marketing expenses will be 6.0% of that year's revenue, and so on.

6. Income taxes can be assumed to be a flat 28% for all income levels.

7. Edward will draw a suitable salary for working for the company that is included in the COGS. Based on the above scenario, complete the following exercises:

Exercise 1: Edward believes that he can get bank financing for 75% of the assets (equipment, building, and working capital) over a seven-year period at an APR of 7% compounded monthly. He plans to put in the rest of the money with a loan from his family, which he will pay back in 10 equal yearly installments with no interest. Edward estimates the business can be sold for $900,000 at end of Year 10.

a. What will be the IRR for the project?

b. What will be the NPV for his investment if MARR was 11%?

c. What will be the EUAB that the business will be able to generate over the 10-year period?

Exercise 2: There is a possibility that Edward can invest in another set of equipment which costs $70,000 less but which will generate revenues of only $200,000 in the first year, with the rest of the cost structure staying the same as described above. He still believes that he can get bank financing for 75% of the assets including working capital over a seven-year period at an APR of 7% compounded monthly. He plans to put in the rest of the money with a loan from his family, which he will pay back in 10 equal yearly installments with no interest. If Edward estimates that the business can be sold at the end of the 10-year period for $700,000:

a. What will be the IRR for the project?

b. What will be the NPV for his investment if the MARR was 11%?

c. What will be the EUAB that the business will be able to generate over the 10-year period?

d. What is the Delta IRR of the original scenario over this one?

e. Should Edward go in for this scenario rather than the original one at an MARR of 11%?

Exercise 3: If Edward believes that he needs to get a bonus of $20,000 per year for the extra effort that he will be putting into the business, for what price should the first scenario option sell for at the end of 10 years? The bonus will be treated as an additional expense and will be included as a part of the COGS.

Exercise 4: If Edward finds that his product qualifies for an investment credit of 25% of his project cost (equipment, building, and working capital) in the original scenario, which he can claim as income at the end of the first year for which he will have to pay taxes at the regular rate in the first year:

a. What will be the IRR for the project?

b. What will be the NPV for his investment if the MARR was 11%?

c. What will be the EUAB that the business will be able to generate over the 10-year period?