Question:
PARC, a large profitable firm, has an opportunity to expand one of its production facilities at a cost of $375,000. The equipment is expected to have a useful life of 10 years and to have a resale value of $25,000 after 10 years of use. If the expansion is undertaken, PARC expects that their income will increase by $60,000 for year 1, and then increase by $5000 each year through year 10 ($65,000 for year 2, $70,000 for year 3,..., $105,000 for year 10). If the equipment is purchased, PARC will depreciate it using a 7 year class life and MACRS depreciation. PARC will receive a 10% investment tax credit if the equipment is purchased.
The annual operating cost for the expansion is expected to be $5,000 for the first year and to increase by 5% per year ($5250 for year 2, $5512.50 for year 3, ..., $7756.64 for year 10). If the equipment is purchased, PARC will pay $175,000 down and finance the balance with a 5-year 12% loan payable in annual payments. Since PARC is a "large and profitable" firm their tax rate is 46% and their ordinary gains are taxed at a rate of 28%.
What is the After Tax Rate of Return for PARC? Given the current economy, would you suggest PARC do the expansion?