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:
Design already happened and is  (answer either “sunk” or “initial”) cost.
According to the bonus depreciation schedule, depreciation in year 1 will be $  . (Round to the nearest dollar.)
Depreciation in years 2 and 3 will be $  . (Round to the nearest dollar.)
Complete the capital budgeting analysis for this project below: (Round to the nearest dollar.)

(Download to Excel)

	Year 0	Year 1	Year 2	Year 3
Sales	$0	$2,400,000	$2,400,000	$2,400,000
- Cost of Goods Sold	$	$	$	$
Gross Profit	$	$	$	$
- Depreciation	$	$	$	$
EBIT	$	$	$	$
- Tax	$	$	$	$
Incremental Earnings	$	$	$	$
+ Depreciation	$	$	$	$
- Incremental Working Capital	$	$	$	$
- Capital Investment	$	$	$	$
Incremental Free Cash Flow	$	$	$	$

The NPV of the project is $  . (Round to the nearest dollar.)

Answer 1

The design will be considered as a sunk cost as it has already happened.

The depreciation, as mentioned in the question, is charged as 100% in the year 1. Hence, depreciation for year 2 and 3 is 0.

If you have any doubt, ask me in the comment section please.