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 $1.6 million. The machine will be depreciated on a straight-line basis over 5 years (that is, the company’s depreciation expense will be $320,000 in each of the first four years (t = 1, 2, 3, and 4). The company anticipates that the machine will be sold when the project expires at a salvage value of $400,000.
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 $146,000 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 11 percent.
The company’s tax rate is 30 percent.
1. What is the net present value of the proposed project?
2. The Parker Products’ policy is to recover the cost of this type of project within 3 years. What is the payback period for the project?
3. What should Parker Products do about this project? Accept or reject? Provide arguments for your answer.