Problem:
A manufacturing company is thinking of launching a new product. The company expects to sell $950,000 of the new product in the first year and $1,500,000 each year thereafter. Direct costs including labor and materials will be 55% of sales. Indirect incremental costs are estimated at $80,000 a year. The project requires a new plant that will cost a total of $1,000,000, which will be a depreciated straight line over the next 5 years. The new line will also require an additional net investment in inventory and receivables in the amount of $200,000.
Assume there is no need for additional investment in building the land for the project. The firm's marginal tax rate is 35%, and its cost of capital is 10%. Prepare a statement showing the incremental cash flows for this project over an 8-year period.
Q1. Calculate the payback period (P/B) and the net present value (NPV) for the project.
Q2. Answer the following questions based on your P/B and NPV calculations:
- Do you think the project should be accepted? Why?
- Assume the company has a P/B (payback) policy of not accepting projects with life of over 3 years.
- If the project required additional investment in land and building, how would this affect your decision? Explain.