Rio Grand Bookstores is considering a major expansion of its business. The details of the proposed expansion project are summarized below:
The company will have to purchase $480,000 in equipment at t = 0
Installation costs of the equipment will be $20,000
The project has an economic life of four years
The cost can be depreciated on a MACRS 3-year basis, which implies the following depreciation schedule: Year MACRS Depreciation Rate 1 0.33 2 0.45 3 0.15 4 0.07
At t = 0, the change of net operating working capital is expected to be $40,000.
The change in net operating working capital is expected to be fully recovered at t = 4
The project’s salvage value at the end of four years is expected to be $10,000
The company forecasts that the project will generate $320,000 in revenue the first two years (t = 1 and 2) and $200,000 in revenue during the last two years (t = 3 and 4)
The company’s tax rate is 40 percent
What is the investment outlay? (That is, what is the Year 0 net cash flow?)
a. What is the depreciation schedule?
b. What are the net operating cash flows in Years 1, 2, 3 and 4? (Show all work as to how you computed yearly cash flows t = 0,1,2,3,4.)
c. What is the terminal cash flow?
d. What is the net present value (NPV) of the proposed project if the project’s cost of capital is 10 percent?
e. Should the machine be purchased? Why or why not?