Envelope Machine

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1.Envelope machine

FCI is deciding on whether to buy a machine that makes envelopes for their cards. The cost of envelopes is one of FCI’s largest cost components. Referring to Ms. Beaumont’s estimations the project would generate $218 000 increase in profit after taxes every year during its eight year economic life. Cost of acquiring the machine is 500,000. If we suppose that FCI is able to convince banks to loan $500,000 to invest in the envelope machine, we can first use FCI’s normal interest rate on bank credit (11%: 8,5% prime + 2,5% FCI marginal) as a discount rate to count the project’s NPV. Here we also assume that FCI will pay the loan back in two and half years.

YearCFDisc. CFLoan due:Int. Exp.:
0-500-500
1218196,4021855,00
2218176,9321865,45
3218159,406423,53
4218143,60
5218129,37
6218116,55
7218105,00
821894,60
621,85 143,98

NPV = 621,85-143,98
=477,87

If we assume that FCI is able is able to capture all gains from the interest rate tax shield and use 35% as a corporate tax rate, it presents an additional 0,35*$143,98 = $50,393 future value to FCI. The envelope machine investment is not very sensitive to changes in the discount rate. 11% might not be even close to company’s cost of equity, which presents the minimum requirement for FCI’s new investments. Again, without considering tax shield, project NPV breaks close to even with a discount rate of 21%. To make the following highly pessimistic for illustrative purposes, we assume that 21% is the interest rate on FCI debt (12,5% marginal on current prime rate):

YearCFDisc. CFLoan due:Int. Exp.:
0-500-500
1218180,17218105,00
2218148,90218130,88
3218123,066449,38
4218101,70
521884,05
621869,46
721857,41
821847,44
312,18 285,26

In this case the future value of gains from the tax shield, if fully utilized, is: 0,35*$285,26 = $99,841. In the...
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