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A company has developed improvements to a product line. The plant can be converted in one of two ways. For $19.5 million the plant (Type 1) will be able to produce three models of a vacuum cleaner, which all rely on similar parts.

A company has developed improvements to a product line. The plant can be converted in one of two ways. For $19.5 million the plant (Type 1) will be able to produce three models of a vacuum cleaner, which all rely on similar parts. For an extra $3.5 million (total initial investment of $23 million) the plant (Type 2) can be equipped with assembly machinery that would allow it produce a much larger range of models of vacuums. Analysts at the company believe that there is a 60% chance that demand for the vacuum line will be high and 40% that demand will be low. The after-tax incremental cash flows for the vacuum are shown in the following table. All amounts are in thousands (000s) and arrive at year end.
Year 1 2 3 4 5 6
High Demand (60%) cash flow 5000 7000 9000 9000 9000 9000
Low Demand (40%) cash flow 1200 1200 1200 1200 1200 1200
Weighted average after-tax cash flow 3480 4680 5880 5880 5880 5880
For $500,000 the Type 2 plant can be switched between vacuum size categories. If demand for the vacuum is low during the first year, the plant can be modified to one of the company’s flagship intermediate vacuums. The cash flows presented in the bottom row below show the $500,000 switching cost at the end of Year 1 ($1.2 million from low vacuum sales less the $500,000 switching cost and a series of $4 million cash flows for Years 2 through 6. All amounts are in thousands, so 5000 is $5 million.
Year 1 2 3 4 5 6
Vacuums Low Demand CFs 1200 1200 1200 1200 1200 1200
Cash flows after switching 700 4000 4000 4000 4000 4000
A. Compute the NPV of the Type I plant using a 12% discount rate.
B. Compute the NPV of the Type II plant using a 12% discount rate and assuming that if vacuum demand is low that the plant switches to the production of intermediate size cars after Year 1.
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