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Capital budgeting - NPV

Your company wants to develop a new product. To date, your company has invested about $4 million in development of the new product. If you choose to pursue the project, it will require an investment of $3 million today and an additional $2 million next year (one year from today). The $3 million is for labor and is immediately tax deductible. The $2 million (one year from today) is for capital equipment that will be depreciated over 5 years, beginning at the end of year 2, with a salvage value using the straight line method. You expect to be able to sell the product for 7 years, and after year 8 the salvage value for the fully depreciated assets will be $500,000. At the end of the first year a working capital investment of $1.5 million will be required. The working capital will be recovered at the end of the product life.

Estimated earnings before depreciation and taxes are below (the numbers are revenue minus COGS and GA&S expense). Assume your company has enough income from other products to take full advantage of all depreciation tax shields.

Year, Initial investment, EbDT
0, 3,000,000,
1, 2,000,000,
2, , 1,500,000
3, , 2,000,000
4, , 2,500,000
5, , 2,500,000
6, , 2,500,000
7, , 2,225,000
8, , 2,225,000

Use a 30% tax rate and a 14.5% discount rate to compute the NPV, IRR, and payback of this investment. Show annual after-tax cash flows used to compute NPV and IRR.

Solution Summary

The solution explains how to calculate annual cash flows and determine the NPV and IRR