Superior Manufacturing is thinking of launching a new product. The company expects to sell $950,000 of the new product in the first year and $1,500,000 each year thereafter. Direct costs including labor and materials will be 55% of sales. Indirect incremental costs are estimated at $80,000 a year. The project requires a new plant that will cost a total of $1,000,000, which will be depreciated straight line over the next five years. The new line will also require an additional net investment in inventory and receivables in the amount of $200,000. Assume there is no need for additional investment in building and land for the project. The firm's marginal tax rate is 35%, and its cost of capital is 10%. Based on this information you are to complete the following tasks.
Prepare a statement showing the incremental cash flows for this project over an 8-year period.
Calculate the Payback Period and the NPV for the project.
Based on your answer for question 2, do you think the project should be accepted? Why? Assume Superior has a P/B policy of not accepting projects with life of over three years.
If the project required additional investment in land and building, how would this affect your decision? Explain.
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See attached documents.
1. Prepare a statement showing the incremental cash flows for this project over an 8-year period.
First of all we need to order the data and do some preliminary calculations.
The total initial investment (I) is the sum of the investment in plant and equipment.
I = $1,000,000
The additional net investment in inventory and receivables is the working capital needed for the project:
WC = $200,000
assuming that it will not change over the project's life. Then Working Capital Change for each year Yi is:
ChWCi = Previous Year WC - Current WC = 0 (i=1 to 7)and
ChWC0 = -$200,000
The working capital is recovered so for the end of the year 8 it will be zero or:
ChWC8 = $200,000
For the first five years Yi (i = 1 to 5):
Di = (Invest in plant and equipment) / 5 = $1,000,000/5 = $200,000
For the years 6 to 8 the depreciation will be zero.
For the first year the expected revenues will be:
R1 = $900,000
For the years Yi (i=2 to 8)
Ri = $1,500,000
For all years we will have indirect incremental costs of $80,000
For each year the direct costs are 0.55*Ri
For each year Yi (i=1 to 8):
Ei = $80,000 + 0.55*Ri then:
E1 = $80,000 + 0.55*$950,000 = $602,500
For i=2 to 8:
Ei = $80,000 + 0.55*$1,500,000 = $905,000
The firm's marginal tax rate is 35%, and ...
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