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Finance: Capital budgeting explained

A manufacturing company 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 a depreciated straight line over the next 5 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 the land for the project. The firm's marginal tax rate is 35%, and its cost of capital is 10%.

- Prepare a statement showing the incremental cash flows for this project over an 8-year period.
- Calculate the payback period (P/B) and the net present value (NPV) for the project.

- Answer the following questions based on your P/B and NPV calculations:

- Do you think the project should be accepted? Why?
- Assume the company has a P/B (payback) policy of not accepting projects with life of over 3 years.
- If the project required additional investment in land and building, how would this affect your decision? Explain.

Solution Summary

The problem set deals with determining whether a venture is profitable by assessing the net present value and profitability of the venture.

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