Cooper Laboratories - Capital Budgeting Multiple Option

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Now compute the NPV of the option 2 as follows,

NPV = 366,000/1.16 + 756,000/ 1.162 + 906,000/1.163 + (906,000 + 240,000)/1.167

NPV = $3,163,900

Q 2 All part written:

Now the question is, should choosing option one and two make difference from doing nothing. To check whether these options have difference with doing nothing and keep the existing production was if there was incremental cash flows were associated with these options. As calculated above, both option one and two have positive incremental cash flows and both have positive net present value so that means these options add value to the value. So, those options add value to the firm clearly different from do nothing option. And net present value tell exactly how much value added to the firm from undertaking these options. So, if these options where ignore then Cooper laboratories missed the chance to add value to their firm.

Q 3:

The next question that’s very important to evaluate the expansion project is how to incorporate the value of land, administrative salaries and computer equipment cost. As land is vacant and only use as parking so there is no visible opportunity cost associated with it yet but in future opportunity cost may be associated but that should be not much significant so we assume to neglect land value in the capital budgeting analysis of expansion of plant. Now, move toward the administration salaries which will save from layoff the employees from year 2, amount to $150,000 to the Cooper laboratories because they shift these staff to Sonica project in last six month of year 1. So, in second half of year 1 Sonica project should bear the cost of these employees. Administrative cost for a year is $150,000 so six months administrative cost will $75,000 (150,000/12*6). Now the next thing to evaluate is the cost of computer. As mentioned in the case Cooper laboratories have excess computers cost of $400,000 have seven years live purchase two years ago that will work for Sonica project for five years so Sonica should have to bear cost of computer in year six and seven years. So assume this cost will remain constant in year 6 and 7 so find the one year cost of computer we should have to find the one year cost of computer using financial calculator. The one year cost of computer in year 6 and year 7 will $87,719 using Cooper discount rate of 12% because it less risky than Sonica project (n=7; I/Y = 12%; PV = 400,000; CPT PMT = 87,719). The computer annual cost should adjust for taxes when calculating cash flows related to expansion project.

Q 4

After having these assumptions now we can calculate cash flows of expansion project. Before calculating the cash flows we should know the incremental variable cost, marketing cost net working capital requirement. Currently variable cost for a unit was $125,000 and sells 40 units of Sonica equipment. Current marketing cost was $20,000 and working capital requirement was 12% of sales. So, incremental working capital can be calculated through taking difference from between two years. The projected sales unit of the expansion project is 55 units in year 1, 120 units in year 2 and 170 unit thereafter till year 7. And there variable costs will $125,000 in year 1 then $118,000 in year 2 and thereafter $115,000 till year 7. The marketing expenses under expansion project will $860,000 in year 1 then $265,000 in year 2 and thereafter $90,000 till year 7. Below table summarizes the results above mentioned incremental cost related to expansion project.

Year 1

Year 2

Year 3 - 7

Option 3

Old Prod.

Incremental

Option 3

Old Prod.

Incremental

Option 3

Old Prod.

Incremental

Sales

11,000,000

8,000,000

3,000,000

24,000,000

8,000,000

16,000,000

34,000,000

8,000,000

26,000,000

Variable cost

6,875,000

5,000,000

1,875,000

14,160,000

5,000,000

9,160,000

19,550,000

5,000,000

14,550,000

Marketing expense

860,000

20,000

840,000

265,000

20,000

245,000

90,000

20,000

70,000

Working capital requirement shown in the table below,

Current Year

Year 1

Year 2

Year 3

Year 4-7

Option 3

Incremental

Option 3

Incremental

Option 3

Incremental

Option 3

Incremental

Sales

8000000