Question

Your company has been doing well, reaching $1 million in earnings, and is considering launching a new product. Designing the new product has already cost $500,000. The company estimates that it will sell 800,000 units per year for $3.00 per unit and variable non-labor costs will be $1.00 per unit. Production will end after year 3. New equipment costing $1 million will be required (at year 0). The equipment will be depreciated using 100% bonus depreciation under the 2017 TCJA (i.e. the equipment can be completely depreciated in year 1). You think the equipment will be obsolete at the end of year 3 and plan to scrap it. Your current level of working capital is $300,000. The new product will require the working capital to increase to a level of $380,000 immediately, then to $400,000 in year 1, in year 2 the level will be $350,000, and finally in year 3 the level will return to $300,000. Your tax rate is 21%. The discount rate for this project is 10%. Do the capital budgeting analysis for this project and calculate its NPV.
Note: Assume that the equipment is put into use in year 1.

Answer 1

New equipment cost 10,00,000

Sale Price 3

Variable cost (1)

Profit 2 * 800000 units= $16,00,000

Particulars	Year 0	Year1	Year2	Year 3	Year4
New equipment cost	(1000000)
Working capital	(80000)	(20,000)	50,000	50,000
Tax Savings on depreciation(1000000*21%)		210000
Profit net of tax 1600000(1-.21)					1264000
Total outflows/inflows	(1080000)	190000	50000	50000	1264000
PVF @10%	1	0.909	0.826	0.751	0.683
Present value	(1080000)	172710	41300	37550	863312

NPV = $34,872

Assumption : Designing cost of $500000 will be considered as sunk cost.

The project is showing a positive NPV. It should be accepted. On the contrary designing cost has not been included being a sunk cost. Although it has been incurred for the designing of the product. The designing cost is already in excess to current NPV of project.