Posted by John on Monday, November 2, 2009 at 5:45pm.
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.
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