Question

ABC Auto Corporation is evaluating the feasibility of producing a newly invented hybrid car. The new model will enable drivers to use both gas and electricity to fuel the car. It also has a lot of new build-in functions superior to other similar cars in the market. The company has already spent $0.5 million over the past 2 years in developing and testing this new car model. To make sure the car will hit the market successfully, ABC recently hired a consulting firm to do a thorough marketing research. The firm charged ABC $30,000 for this service.

The new project will require an initial investment of $12 million in equipment.   The project is expected to run for 3 years, and the equipment purchased for this project will then be sold at the market after 3 years of use. The equipment will be depreciated using straight-line method for 3 years. Its market salvage value after 3 years is estimated to be $450,000.

This project will create $700,000 sales and help the company to save $150,000 costs in each year. The discount rate that company uses is 12%, and its corporate income tax rate is at 40%.

As the CFO of ABC Auto Co., you are asked to conduct capital budgeting analysis, and then provide your recommendation to the board of directors in an executive summary.

1. Identify which of the cash flow described in the case are incremental cash flow (i.e. relevant and needed in capital budgeting analysis). Provide your brief explanation for your answer.
2. Calculate each year’s incremental cash flow: year 0 (initial time), year 1, year 2, and year 3. You MUST show your work to earn credit
3. Use 3 methods (NPV, IRR, Payback) to separately evaluate the project. You MUST show your work.

Answer 1