Question

Electric Youth, Inc. (EY) is a perfume manufacturer. The company is interested in buying a new perfume-filling machine to make a new type of perfume as a separate project for the firm. The new machine costs $1,000,000 and they typically use the straight-line method to depreciate their assets. They believe that with the new machine, revenues from this particular type of perfume will increase by $650,000 per year. Operating costs (not including depreciation) associated with the machine are estimated to be $300,000 per year. The project is expected to last for five years; this is also the useful life of the machine. When the project is complete, they plan to recycle the machine (which means it has a zero salvage value at the end of its useful life). They would need to make an immediate investment in inventory of $25,000, which would be unwound in the terminal year of the project. The tax rate for the firm is 22%. To do:

a) Calculate the cash flows (years 0 to 5) for this investment. You can do this in Excel if you would like (cut and paste into the Word document).

b) Given a cost of capital of 11%, calculate the NPV of this project. Show your work. Is this a good investment? Why or why not?

Answer 1