Cash flows & cost of capital

Riverlea Swine is considering a proposal to manufacture high-protein pig feed. The project would make

use of an existing warehouse, which is currently rented out to a neighbouring firm. The next year’s rental charge

on the warehouse is $100,000, and thereafter the rent is expected to grow in line with inflation at 4 percent a

year. In addition to using the warehouse, the proposal envisages an investment in plant and equipment of

$1.2 million.

This could be depreciated for tax purposes straight-line over 10 years. However, Riverlea Swine expects

to terminate the project at the end of eight years and to resell the plant and equipment in year 8 for $400,000.

Finally, the project requires an initial investment in working capital of $350,000.

Year 1 sales of pig feed are expected to be $4.2 million, and thereafter sales are forecast to grow by

5 percent a year, slightly faster than the inflation rate. Manufacturing costs are expected to be 90 percent of

sales, and projects are subject to tax at 30 percent. The cost of capital is 12 percent.

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