Bouchard Industries is a Canadian company that manufactures gutters for residential houses. Its management believes it has developed a new process that produces a superior product. The company must make an initial investment of C$190 million to begin production. If demand is high, cash flows are expected to be C$40 million per year. If demand is low, cash flows will be only C$20 million per year. Management believes there is an equal chance that demand will be high or low. The investment also gives the company a production-flexibility option allowing the company to add shifts at the end of the first year if demand turns out to be high. If the company exercises this option, net cash flows would increase by an additional C$5 million in Years 2–10. Bouchard’s opportunity cost of funds is 10%.
The internal auditor for Bouchard Industries has made two suggestions for improving capital allocation processes at the company. The internal auditor’s suggestions are as follows:
Suggestion 1“In order to treat all capital allocation proposals in a fair manner, the investments should all use the risk-free rate for the required rate of return.”
Suggestion 2“When rationing capital, it is better to choose the portfolio of investments that maximizes the company NPV than the portfolio that maximizes the company IRR.”
Question
Q. What is the NPV (C$ millions) of the optimal set of investment decisions for Bouchard Industries including the production-flexibility option?
- –C$6.34 million
- C$7.43 million
- C$31.03 million
