Johnson Chemical Company has just received a special subcontracting job from one of its clients. This 2-year project requires purchase of a special-purpose pointing sprayer for $60,000.
This equipment has a 30% declining balance rate for CCA calculations. After the subcontracting work is completed, the painting sprayer will be sold at the end of 2 years for $40,000 (actual dollars). The painting system will require an increase in net working capital (spare parts inventory such as spray nozzles) of $5000. This investment in working capital will be fully recovered at the end of project termination.
The project will bring in additional annual revenue of $120,000 (today's dollars), but it is expected to incur additional annual operating costs of $60,000 (today's dollars). It is projected that, due to inflation, there will be sales price increases at an annual rate of 5%. (This implies that revenues will increase at an annual rate of 5%). An annual increase of 4% for expenses and working capital requirement is expected.
The company has a marginal tax rate of 30% and it uses a market interest rate of 15% for project evaluation during the inflationary period. If the firm expects a general inflation of 8% during the project period:
(a) Compute the after-tax cash flows in actual dollars.
(b) What is the rate of return on this investment (real earnings)?
(c) Is this special project profitable?