A firm that manufactures and sells ball bearings currently has excess capacity. The firm expects that it will exhaust its excess capacity in three years. At that time, it will spend $5 million, which represents the cost of equipment as well as the value of depreciation tax shields on that equipment, to build new capacity.
Suppose that this firm can accept additional manufacturing work as a subcontractor for another company. By doing so, the firm will receive net cash inflows of $250,000 immediately, and in each of the next two years.
However, the firm will also have to spend $5 million two years earlier than originally planned to bring new capacity on line. Should the firm take on the subcontracting job?
The discount rate is 12 percent. What is the minimum cash inflow that the firm would require (per year) to accept this job?