A firm believes it can generate an additional $4,000,000 per year in revenues for the next 5 years if it replaces existing equipment that is no longer usable with new equipment that costs $5,100,000. The new equipment will likely be able to be sold for $100,000 at the end of the project (after 5 years). The additional sales will require an initial investment in net working capital of $400,000, which it expects to recover at the end of the project (after 5 years). The existing equipment has a book value of $25,000 and a market value of $20,000. The contribution margin is expected to be 55% of revenue. Assume the firm uses straight-line depreciation, its marginal tax rate is 35%, its weighted-average cost of capital is 14%, and the risk of this project is similar to the risk of its other projects.
a) When will the initial cash outflow be recovered?
b) How much value will this new equipment create for the firm?
c) At what discount rate will this project break even?
d) Should the firm purchase the new equipment? Be sure to justify your recommendation.
e) How would your analysis change if this project was less risky than the firm’s other projects? Be specific.