Problem:
Parker Products manufactures a variety of household products. The company is considering introducing a new detergent. The company's CFO has collected the following information about the proposed product. (Note: You may or may not need to use all of this information, use only the information that is relevant.)
- The project has an anticipated economic life of 4 years.
- The company will have to purchase a new machine to produce the detergent. The machine has an up-front cost (t = 0) of $2 million. The machine will be depreciated on a straight-line basis over 4 years (that is, the company's depreciation expense will be $500,000 in each of the first four years (t = 1, 2, 3, and 4). The company anticipates that the machine will last for four years, and that after four years, its salvage value will equal zero.
- If the company goes ahead with the proposed product, it will have an effect on the company's net operating working capital. At the outset, t = 0, inventory will increase by $140,000 and accounts payable will increase by $40,000. At t = 4, the net operating working capital will be recovered after the project is completed.
- The detergent is expected to generate sales revenue of $1 million the first year (t = 1), $2 million the second year (t = 2), $2 million the third year (t = 3), and $1 million the final year (t = 4). Each year the operating costs (not including depreciation) are expected to equal 50 percent of sales revenue.
- The company's interest expense each year will be $100,000.
- The new detergent is expected to reduce the after-tax cash flows of the company's existing products by $250,000 a year (t = 1, 2, 3, and 4).
- The company's overall WACC is 10 percent. However, the proposed project is riskier than the average project for Parker; the project's WACC is estimated to be 12 percent.
- The company's tax rate is 40 percent.
What is the net present value of the proposed project?