You are asked to evaluate a 2-year project that requires the acquisition of an equipment.
The equipment costs $800,000, and falls into the MACRS 3 year class. The equipment will be sold after TWO years for 25% of its purchase price. The initial (at t=0) net working capital (NWC) requirement is 12% of the equipment cost. The project will increase the firm's annual revenues by $250,000, and reduce annual operating costs by $120,000, respectively, in Year 1. Afterwards, annual revenues and annual operating costs will grow at nominal rates of 5% and 3%, respectively, over the life of the project. The NWC requirement is expected to grow at an inflation rate of 2% annually. In addition, you conducted a $200,000 pilot study for the project last year. There is also growing pressure from headquarters to impose an annual amount of $100,000 from the existing fixed corporate overhead expenses on the project. The firm's tax rate is 35%. The nominal cost of capital is 14%.
(a) Compute the initial cash flow of the project.
(b) Compute the total cash flows for Years 1 and 2. Note that the project will be terminated at the end of Year 2.
(c) What is your recommendation on this project according to your calculation that bases on the conceptually most correct capital budgeting method? Why?
The project should not be implemented.
On the basis of net present value method, the project has a negative NPV hence it is not advisable to implement the project because it will generate negative cashflows.