Question
A firm believes it can generate an additional $260,000 per year in revenues for the next 5 years if it replaces existing equipment that is no longer usable with new equipment that costs $280,000. The firm expects to be able to sell the new equipment when it is finished using it (after 5 years) for $20,000. The existing equipment has a book value of $35,000 and a market value of $25,000. Variable costs are expected to total 70% of revenue. The additional sales will require an initial investment in net working capital of $26,000, which is expected to be recovered at the end of the project (after 5 years). Assume the firm uses straight line depreciation, its marginal tax rate is 35%, and its weighted-average cost of capital is 10%.
a) How much value will this new equipment create for the firm?
b) At what discount rate will this project break even?
c) Should the firm purchase the new equipment?