Imagine you work as a financial consultant for Gaga Audio, a Canadian company that produces music instruments. You are asked to analyze alternative uses for a building the company has purchased three years ago for $2,500,000. Gaga Audio could continue to rent the building to
the present tenants for at least another 20 years at $130,000 per year. Alternatively, the company can modify the building to manufacture either electrical guitars or electrical pianos. The revenue and cost data for these two products are as follows:
Initial cash outlay for building modification $400,000 $500,000
Initial cash outlay for machines $1,150,000 $1,400,000
Salvage value machines $335,000 $500,000
Annual pretax cash revenue (generated for 20 years)
Annual pretax cash expenditure (generated for 20 years)
The building will be used for only 20 years to produce the guitars or the pianos. After 20 years Gaga Audio plans to rent the building to tenants similar to the present tenants. To rent out the building again, the company will need to restore the building to its present layout. The estimated cash cost of restoring the building will be $80,000 if guitars were manufactured and $100,000 if pianos were manufactured. These costs can be deducted for tax purposes in the year the expenditure occur. The original building has a CCA rate of 5%. The building modifications will be depreciated using the straight‐line method over a 20 year life. Machines have a CCA rate of 20%. Both asset classes remain open. The relevant tax rate is 40% and the required rate of return is 12%. Assume all cash flows for a given year occur at the end of the year. The initial cash flows for modifications and machines will occur at t=0 and the restoration cash flows will occur at the end of the year 20. What advice would you give Gaga Audio: should the company use the building to manufacture guitars, electrical pianos or should it continue to rent out the building? Explain.