Rare Portcullises is a company specialized in gates and steel structures of rare quality, which operates in Italy since the ‘40s.
The company is currently (year 0) considering an investment in a new technique of zincing for horizontally pivoted shutters.
The project is particularly important because it would add a new production line to the existing business but the mangers are afraid that this choice could generate some cannibalization costs with potential damage for the firm.
Therefore, the expectations about incremental sales and expenses are combined with a forecast about likely cannibalization effects.
The analysis shows that there is a probability of 70% of consequential damage.
In terms of expected value the cannibalization costs will arise during the early two years of the project, eroding respectively 10% and 12% of the differential expected sales.
It is also know that two years ago the company requested a survey about the market size for this kind of products, and still has to pay the Advisory fee of 49.000 € to the Advisory company.
In addition, two of the existing employees, currently working in the zincing department, should be moved to the new production. Please consider that the salary of 60.000 € per year that they perceive will not change in case of realization of the new project.
The new investment will generate operating monetary expenses, steady and equal to the 20% of the incremental turnover during the next five years of useful life of the project.
The company estimated that the venture is going to generate an investment in working capital of 18000 € each year from year 1 to year 5 included. The total amount of working capital will be collected in a single settlement during the year of equipment disposal.
Given the high specificity of the equipment, Rare Portcullises Inc. thinks that during the sixth year is going to divest the project, but not at a very high price. In fact the machinery, which generates capital expenditures during the year 0 for 800.000 € and has a straight line depreciation over 10 years, will
allow proceeds from disposal during January of year 6. Rare Portcullises in January of the sixth year will realize a capital loss equal to 10% of the machinery book value as registered at the end of the fifth year.
In order to carry on a correct valuation of the project, Rare Portcullises Inc. has to take into consideration its financial structure, composed by debt (30% of total funds, with a kd equal to 6%) and by equity (70% of total funds, with a keL equal to 9%). The discount rate can be calculated applying the previous data to a normal Weighted Average Cost of Capital formula.
The taxation rate for the company is 27,5%. Given all the available information about the project, what do you suggest to the company?
Incremental sales forecast:
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