Question

A company is intending to invest in a capital budgeting project to manufacture a medical testing device and has projected the following sales:

Year 1. $50,000

Year 2. $66,400

Year 3. $81,200

Year 4. $68,500

Year 5. $54,500

The installed cost of the new assets will be $18,500,000 which will be depreciated using the 7-year MACRS schedule. The assets will have a salvage value of $3,700,000. Initial NWC requirements are $1,500,000 and additional working capital needs are estimated to be 15% of the projected sales increases for the following year. Total fixed costs are $2,000,000 per year. The medical device has a selling price of $300 per unit and variable production costs are $175. The firm has a marginal tax rate of 35% and a required rate of return of 18%. Analyze this project and give your recommendation as to whether they should invest in it or abandon it.

Answer 1

The project can be evaluated using NPV method.

However in this case, the sales is much less as compared to fixed cost. Hence the annual cash flow can never turn positive and the project will not be viable. Hence they should abandon it upfront.

I think there is an error in the question, projected sales is in no. of units of medical testing device and not the sales value,

Please comment if the above correction is required, I will answer the question considering it.