Question

The Boring Company makes sleep devices that simulate listening to college lectures on droll subjects. Boring just spent $1 million to bring its plant into compliance with earthquake codes and another $500,000 hiring a consultant to help it develop more stimulating products. It can now spend an additional $10 million for equipment that will allow it to make a new range of alarm clocks which it thinks will be a big seller for the next 5 years. In deciding whether to make these alarm clocks, The Boring Company uses a discount rate of 10%. The Boring Company has an annual interest expense of $300,000. The Boring Company’s tax rate is 35 percent. The $10 million in equipment will be straight line depreciated to a salvage value of zero over 5 years. The Boring Company actually expects the equipment to be worth $1 million at the end of 5 years. If Boring goes ahead with the project, it will immediately need an additional $2 million for an increase in the net working capital that it needs to make these alarm clocks but expects that it can reduce the working capital by $1 million after the first year of production. Boring expects to sell 1 million alarm clocks each year for 5 years at which point the project will come to an end. Each alarm clock costs $1.00 to make and will be sold for $3.00. Should they go ahead with the alarm clock project?

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Answer 1