Wakanda is considering building a new vibranium (a fictional metal) plant that uses some recently developed technology that will greatly reduce production costs. You have been employed as a consultant for Wakanda’s VP of Finance to help with this decision.
Wakanda must buy land for the plant. You estimate that the acquisition cost of the land is $10 million, assuming that you acquire the land immediately. Construction of the factory building and installation of the equipment is expected to take two years and cost $35,000,000 (payable $15 million today, and $10 million at times 1 and 2). The cost of the buildings and equipment will be depreciated on a straight-line basis over 20 years. Depreciation will begin during the third year when the plant starts operation.
Additional capital expenditures of $5 million will be necessary in the 5th, 10th, and 15th years of operation for this project ($5 million in each of these three years). This additional capital expenditure will be depreciated on a 5-year straight-line basis. Depreciation for these assets will begin in the year of purchase. While the value of the land and buildings at the end of the project’s life is highly uncertain, the VP of Finance expects that the value should be at least the original $10 million invested in the land adjusted for inflation over the life of the project. Assume sale of the project the year after the last year of operation.
Estimated annual sales are 15,000,000 units of vibranium in each of the first ten years the plant operates. You expect that the quantity produced will decline by 3% per year beginning in the eleventh year of operation. The price of vibranium today is $13.65 per unit.
The engineering staff has provided you with some preliminary cost estimates for the project. Fixed costs to run the plant for one year will be $25,000,000 when the plant starts operation. According to the engineers, additional estimated costs of production are expected to be $14 per unit once the plant is operating – $12.75 of this cost is actually incremental to firm, and $1.25 of this estimate is allocated overhead (i.e., costs that would be incurred by Wakanda regardless of whether the new plant is built but which have been assigned to the proposed new plant for financial reporting purpose). In addition, Wakanda spent $3 million over the past year fine tuning the new technology after it bought the domestic rights to the technology from a Tanzanian firm two years ago for $1 million.
Prices in the economy are expected to increase at 3.5% per year indefinitely. This figure affects output prices, variable input costs, the fixed costs of operating the plant, and the land selling
price. Fixed costs are independent of the level of output but are not constant across time. Wakanda faces a 21% marginal tax rate.
At the end of year 2, accounts payable for Wakanda is expected to increase by $2 million, and inventory is expected to increase by $4 million. These additional amounts will allow Wakanda to begin operation of the plant during year 3. Once the project begins full scale operations, net working capital (cash balance + accounts receivable + inventory – accounts payable and other payables) is expected to have a stable relationship with yearly sales that call for net working capital to be 4% of sales in each year. Wakanda expects to recover the remaining working capital at the end of the project in the year after operation ceases.