Chapter 16 Mini Case #1: Self vs. Debt Financing

Riverside Technologies Incorporated (RTI) is a small firm in North Sioux City, SD which provides

IT solutions for other companies.  In addition to providing IT services and computer hardware (i.e. laptops, desktops, and tablets), RTI has decided to add customized computer bags for companies as well.  Companies can have RTI create computer bags and other accessories with a custom logo. 

Suppose a firm like RTI wants to add embroidery service to their customers.  The firm would need to invest in 10 high-end embroidery machines which can embroider high quality graphics and can handle repeated use on backpacks, laptop cases, and tablet covers.  These machines will cost $10,000 each and have an expected life of 5 years.  The firm will also need to hire someone to operate the machines at a salary of $40,000 per year plus benefits equal to 25% of salary.  The firm provides a cost of living increase to salary (including benefits) of 3% annually.

Suppose the firm has enough in cash reserves to finance this expansion into a new product line themselves; however, they could also take out a loan to finance the expansion.  If financing the expansion themselves, they will be giving up 2.5% interest in a CD account.  If they use a loan to finance the expansion, they are planning to finance it with a 5.75% interest-only loan, which requires that the firm makes interest payment at the end of each year and make a balloon payment of the principal at the end of Year 5. 

The firm’s sales department has assured management they will be able to sell laptop bags, backpacks, or tablet cases to a minimum of 2500 customers.  Each customized items will sell for $50 and costs $15 to purchase and customize.  

  1. Calculate net cash flow each year for both the self-financing scenario and debt-financing scenario.  (Assuming a 10% tax rate)
  2. Find the net present value (NPV) for both the self-financing scenario and debt-financing scenario using either the CD interest rate or loan rate as appropriate. c) How should the firm finance this expansion? Why? 

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