PBC Ltd., a general insurance company, has historically focused its business strategy in eastern Canada. Management is now considering a plan to expand into western Canada and, as a trial, is evaluating the opening of an office in Vancouver. If the office turns out to be a success, the company will then expand into other western Canadian cities. For strategic planning purposes, PBC uses a 4-year planning horizon for all of its capital budgeting decisions.

PBC has determined that suitable office space is available in Vancouver at an annual cost of $100,000, paid at the beginning of each year. Given an excess of rental space, the company believes that it is unlikely that there will be a rent increase for the foreseeable future.
Specialized computer equipment will have to be purchased for the office at a cost $250,000. The computer equipment will be amortized on a straight-line basis over its estimated useful life of 4 years to a salvage value of 20% of original cost. Office equipment will also have to be purchased at a cost of $125,000. The office equipment will be amortized on a straight-line basis over 10 years with zero expected salvage value.

Management believes that the resale value of the office equipment will approximate its book value at any point in time. Finally, an initial investment in net working capital of $50,000 will be required, with this investment being increased by $15,000 at the beginning of the third year.
Based on its current business, management believes that the new office can generate gross revenues of $500,000 in its first year of operation and $750,000 in each of the subsequent 3 years. Costs of operating the office (excluding rent and amortization) are expected to equal 80% of revenues. PBC’s tax rate is 34%, its weighted-average cost of capital is 9%, and the applicable CCA rates on the computer equipment and the office equipment are 30% and 15%, respectively.

Required

a. Based on the net present value (NPV) method, determine if PBC should open the office in Vancouver. (20 marks)

b. As stated above, for purposes of capital budgeting decisions, PBC uses a planning horizon of 4 years.

i) Explain why firms might restrict their planning horizon to a relatively short period such as 4 years.

ii) Explain the potential consequences of this planning horizon for capital budgeting decisions.

a. To determine if PBC should open the office in Vancouver using the net present value (NPV) method, we need to calculate the cash flows associated with the project and discount them to their present value.

1. Cash outflows:
a. Annual rent cost: $100,000 (for each of the 4 years)
b. Computer equipment cost: $250,000
c. Office equipment cost: $125,000
d. Initial net working capital investment: $50,000

2. Cash inflows:
a. Revenue in Year 1: $500,000
b. Revenue in Years 2, 3, and 4: $750,000 each

3. Operating costs:
Operating costs are expected to be 80% of revenues (excluding rent and amortization).

4. Salvage values:
The salvage value of the computer equipment is 20% of its original cost. The office equipment has zero expected salvage value.

5. CCA rates:
The computer equipment falls under the CCA rate of 30%, while the office equipment falls under the CCA rate of 15%.

To calculate the NPV, we need to discount the cash flows to their present value using the weighted-average cost of capital (WACC) of 9%. The NPV formula is as follows:

NPV = (Cash Flow Year 1 / (1 + WACC)^1) + (Cash Flow Year 2 / (1 + WACC)^2) + ... + (Cash Flow Year N / (1 + WACC)^N) - Initial Investment

We calculate the NPV of the project by summing the present values of all cash flows and subtracting the initial investment. A positive NPV indicates that the project is expected to generate a net gain for the company, while a negative NPV indicates a net loss.

b. i) Firms might restrict their planning horizon to a relatively short period such as 4 years because of uncertainties and risks associated with future cash flows and business conditions. The longer the planning horizon, the more uncertain the projections become, making it difficult to accurately estimate future cash flows and determine the viability of the project. By limiting the planning horizon to a shorter period, firms can make more reliable and manageable projections.

ii) The potential consequences of this planning horizon for capital budgeting decisions are:

1. Limited consideration of long-term benefits and risks: By focusing on a shorter planning horizon, firms may miss out on considering the long-term benefits and risks associated with the project. Some costs and benefits might only materialize in the later years, which could impact the overall profitability of the investment.

2. Lack of strategic alignment: Restricting the planning horizon to a shorter period may result in decisions that do not align with the long-term strategic goals of the company. A myopic focus on short-term gains may hinder the company's ability to capture significant opportunities in the future.

3. Ignoring the time value of money: If a project's benefits extend beyond the planning horizon, the potential impacts on future cash flows and the time value of money may not be fully considered or taken into account. This can lead to suboptimal investment decisions.

Overall, while a shorter planning horizon may provide easier and more reliable projections, it may also limit the consideration of long-term benefits and risks, strategic alignment, and the time value of money in capital budgeting decisions.