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.
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.