Question

Your company has been doing​ well, reaching $ 1.04 million in​ earnings, and is considering launching a new product. Designing the new product has already cost $ 489,000. The company estimates that it will sell 840,000 units per year for $ 2.96 per unit and variable​ non-labor costs will be $ 1.05 per unit. Production will end after year 3. New equipment costing $ 1.03 million will be required. The equipment will be depreciated using​ 100% bonus depreciation under the 2017 TCJA. 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 $ 410,000 in year​ 1, in year 2 the level will be $ 352,000​, and finally in year 3 the level will return to $ 300,000. Your tax rate is 21 %. The discount rate for this project is 9.7 %. 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

Designing cost is sunk cost and will be ignored.

Annual earnings after tax = 840000*(2.96-1.05)*(1-0.21)

=1267476

Depreciation tax shield in year 1 = 100%* cost * Tax rate

= 1030,000*21%

=216300.00

Hence the cash flows will be as follows

Year	Initial cost	Tax shield on depreciation	Earnings after tax	Working capital	Cash flows
0	-1030000			-80000	-1110000
1		216300	1267476	-30000	1453776
2			1267476	58000	1325476
3			1267476	52000	1319476
				NPV	$2,316,160.42

WORKINGS