Gary Small is the managing director of the famous Big & Tall Tool company. They are known for the manufacturing of some of the country’s finest tools as used in the automotive sector. With this in mind they are considering a proposal to convert one of their showrooms used for wholesale customers to one that is now open to retail customers. This will hopefully improve the profile of the company and protect it from the threat of cheap inferior foreign made tools. Currently the property where the wholesale showroom is located has a market value of $6m. Estimates for a refurbishment of the premises have been sought and the average cost is in the vicinity of $2m. If they choose to also include a café then the cost of the refurbishment would be a total of $2.5m.
In order to assess the suitability of the upgrade Gary has contracted Martha Little from Giant Consulting to consult on the suitability of the project. Martha’s fees were such that she charged $2500 before the decision to undertake the project was made at the start of the project (year 0) as well as a further $7,500 at the end of year 1 if the project went ahead. This is fully tax-deductible.
As part of the evaluation of the viability of the project Gary and Martha took a trip to inspect some similar premises in the city of Little Valley. The cost of airfares was $2,000 each, food and hotel accommodation $600 each and food $300 each. Such costs are usually tax deductible.
The old premises have a book value of $100,000 and scrap materials after demolition can be sold for $12,000 to a recycling plant, Huge Recycling Pty Ltd if it is sold now. Demolition costs will be $5000 if the project goes ahead and are tax deductible immediately, The upgraded premises will increase retail sales of from $50,000 to $905,000 per year from year 1. This increase is expected to grow by 1% per year. It is expected however that wholesale sales will fall by $125,000 per year. This decrease is expected to be constant. Assume all cash flows are in nominal terms.
Peter Tiny is the current part time maintenance facilitator of the premises and is paid $15,000 per year. With the new premises including a café he will be required to work an extra day per week to deal with pest extermination issues. His new pay will be $20,000 per annum.
Some additional showroom furniture will be required to run the showroom. These presently have a cost of $20,000 if purchased new. However, Gary does have the required furniture in storage. He pefers to use the used furniture. These have a book value of $5000. He recently tried to sell them on Gumtree but was unable to do so.
The cash operating costs of the old showroom were $90,000 per year. The new showroom is more expensive to run and has operating costs of $100,000 in the first year but these decrease by 1% every year thereafter.
An increase in inventory of $32,000 is required immediately, and an additional $5,000 is required annually starting next year. The premises have an expected further useful life of two years. In two years’ time the old premises (if it is kept) could be sold to a scrap metal merchant for about $2,000. There will be no demolition costs in this scenario.
The new premises have an expected life of 10 years and could be sold for $30,000 at the end of this. There would be no demolition costs in this case. The new premises will be depreciated down to zero using the straight-line method. Regarding the new premises, the company plans to depreciate it over the estimated life (ten years). However, the Australian Taxation Office (ATO) stipulates that for tax purposes the effective life of such an asset is 8 years for the premises and 9 years for the café component of the cost. The old premises are currently being depreciated at $50,000 per year. This is in accordance with ATO guidelines.
The company currently sublets a portion of their store space to International Tool Exporters who primarily export tools to Germany and Spain. Currently they pay rent to Big & Small of $5,000 per year. This was expected to increase by 5% at the start of every year. International Tool Exporters will be asked to leave the premises so as to complete the new premises. If the new premises goes ahead, Big & Tall will make a $5000 payment to assist them in this move. This payment is tax-deductible and will occur at the start of the project.
The company plans to borrow the $2.5m required from Big bank to partially finance the upfront costs. They will be charged an interest rate of 3.1% per annum. The interest is tax deductible to the company. The company will pay interest at the end of each year and will repay the original loan at the end of the last year of the project.
Interestingly, Big and Tall owns a nearby café as well. It is felt that sales will drop because of the new competition by about $5000 per year. Big & Tall’s accountant Harry Huge has said that this information is not necessary for the calculation as it is a different premises.
The current rate of inflation is 5.0% p.a. Big & tall pays tax at 30 cents in the dollar and the company’s required real rate of return is 7% p.a. on a project such as this one.
All amounts are in nominal dollars. Assume all cash flows occur at the end of the period unless specified.
You are to prepare an NPV analysis of whether the company should expand their premises (including café) of continue in with the present operations.
You will be assessed on the following criteria:
(a) Calculate the cash flows at the start of the investment?
(b) Calculate the cash flows over the life of the investment? (Hint: the life is 10 years.)
(c) Calculate the cash flows at the end of the investment?
(d) What is the appropriate discount rate for the project? (Remember that the cash flows are in Nominal terms).
(e) What is the Net Present Value of the Project? Should they go ahead with the project.