Blatt Packing Co. is examining the investment in a new air-conditioning system in its factory. The initial cost is £100,000, and it is expected to sell the system for scrap after five years at a salvage value of £20,000. The equipment will be depreciated on a straight-line basis for tax purposes.
The tax rate is 40 per cent, with no tax payable on the salvage value. The investment requires an increase in net working capital of £5,000 at the outset. There is no increase in revenues expected, but there is expected to be a saving of £40,000 per year in before-tax operating costs.
a. Estimate the cash flows involved in the project.
b. If the firm's cost of capital is 8 per cent, should the firm invest in the system?
c. How would the decision above be affected if the firm's bond rating was reduced and its cost of capital changed to 10 per cent?