our company has been doing well reaching 119 million in ear

our company has been doing well, reaching $ 1.19 million in earnings, and is considering launching a new product. Designing the new product has already cost $516,000. The company estimates that it will sell 812,000 units per year for $ 3.02 per unit and variable non-labor costs will be $ 1.18 per unit. Production will end after year 3. New equipment costing $1.15 million will be required. The equipment will be depreciated to zero using the 7-year MACRS schedule. You plan to sell the equipment for book value at the end of year 3. Your current level of working capital is $306,000. The new product will require the working capital to increase to a level of $382,000 immediately, then to $396,000 in year 1, $349,000 in year 2, and finally return to $306,000. Your tax rate is 35%. The discount rate for this project is 9.8%. Do the capital budgeting analysis for this project and calculate its NPV.

Solution

Year 0 1 2 3 Total Marcs Depreciation rate 14.29% 24.49% 17.49% Depreciation Amount 164335 281635 201135 647105 Book value / salvage value 502895 Sales unit 812000 812000 812000 Contribution per unit 1.84 1.84 1.84 Total incremental Contribution 1494080 1494080 1494080 Less Depreciation 164335 281635 201135 Profit before tax 1329745 1212445 1292945 Less: tax @35% 465410.8 424355.8 452530.8 Net income - incremental 864334.3 788089.3 840414.3 Cash flow from operation (NI + Depr.) 1028669 1069724 1041549 Cost of Equipment -1150000 Salvage 502895 Change in WC -76000 -14000 47000 43000 Total cash flow -1226000 1014669 1116724 1587444 DF @ 9.8% 1 0.910747 0.82946 0.755428 Present value -1226000 924106.8 926277.8 1199200 1823584 Net Present value 1823584 Equipment should be bought. Designing the new product has already cost $516,000. This cost has no relevance in decision making as it is sunk cost.