Question

Your company has been doing well, reaching $1.09 million in earnings, and is considering launching a new product. Designing the new product has already cost $539,000. The company estimates that it will sell 812,000 units per year for $3.05 per unit and variable non-labor costs will be $1.16 per unit. Production will end after year 3. New equipment costing $1.05 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 $303,000. The new product will require the working capital to increase to a level of $375,000 immediately, then to $404,000 in year 1, in year 2 the level will be $342,000, and finally in year 3 the level will return to $303,000. Your tax rate is 21%. The discount rate for this project is 9.5%.

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

The free cashflows for the firm are calculated as shown below :

Year	0	1	2	3
No of Units		812000	812000	812000
Selling Price per unit		3.05	3.05	3.05
Variable Cost per unit		1.16	1.16	1.16
Revenue		2476600	2476600	2476600
Less: Variable Cost		941920	941920	941920
Profit Before Tax		1534680	1534680	1534680
Less: Tax @21%		322282.8	322282.8	322282.8
Profit after Tax		1212397.2	1212397.2	1212397.2
Capital Cost (net of Depreciation)	829500
Working capital	375000	404000	342000	303000
Change in Working capital	72000	29000	-62000	-39000
Free Cash flows	-901500	1183397.20	1274397.20	1251397.20

NPV = - 901500+1183397.20/1.095+1274397.20/1.095^2+1251397.20/1.095^3

= $2,195,220.77