We are considering the introduction of a new product. Currently we are in the 34% marginal tax bracket with a 15% required rate of return or cost of capital. This project is expected to last 5 years and then, because this is somewhat of a fad product, be terminated. The following information describes the new project:
Cost of new plant and equipment 7,900,000
Shipping and installation cost 100,000
Unit sales year Unit sold
Sale price per unit $300/unit in years 1 through 4, $260 /unit in year 5
Variable cost per unit $180/unit.
Annual Fixed cost $200,000 per year in years 1-5
Working–capital requirements There will be an initial working – capital requirement of $100,000 just
To get production started. For each year, the total investment in net
Working capital will be equal to 10% of the dollar value of sales for that
Year. Thus, the investment in working capital will increase during year
1 through 3, then decrease in year 4. Finally, all working capital is liquidated at the termination of the project at the end of year 5.
The depreciation method Use the simplified straight line method over 5 years. Assume that
The plant and equipment will have no salvage value after 5 years.
a) Should the company focus on cash flow or accounting profits in making it capital budgeting decisions?
Should the company be interested in incremental cash flows, incremental profits, total free cash flow or total profits?
b. How does depreciation affect the determination of cash flows?
c. How do sunk cost affect the determination of cash flows?
d. What is the project’s initial outlay?
e. What are the differential cash flows over the projects life?
f. What is the terminal cash flow?
g. Cash flow diagram
h. What is its net present value?
i. What is its internal rate of return?
j. Should the project be accepted? Why or why not?
k What are the three measures of a project’s risk in capital budgeting?
l Which measurements or relevant per CAPM?
m Explain how simulation works. What is its value?
n What is sensitivity analysis and its purpose?