Question

Lights-Out Electric Company is considering a contract to manufacture a specialized light switch.The contract calls for the company to deliver 3000 switches per year for 4 years at a price of $30per switch (paid on delivery). Producing the switch will require the use of some existing equipment and investment of $100,000 in new equipment. The variable cost of the switch will be $15 per switch throughout the life of the contract. The existing equipment that would be used is already fully depreciated. If used to make switches, it will not require any maintenance expenditures but it will be worthless at the end of the contract. The company has no other use for the equipment but could sell it now for $10,000. The new equipment that would be used on the switch contract requires no maintenance expenditures but will be depreciated to zero on a straight-line basis over 4 years. At the end of 4years, this equipment can be sold for $15,000.

The cost of capital (RRR) for this project is 10%. Lights-Out’s tax rate is 33%. Should Lights-Out take the switch contract?Assume that all CFs except the initial equipment-related flows occur at the end of years

1. Calculate the Net present value of the contract.

Answer 1

Depreciation = 100000/4 = 25000

after tax salvage value = 15000*(1-0.33) = 10,050

Since NPV is Positive Project can be accepted.