Capital Budgeting

Capital Budgeting

ABC is investigating the feasibility of a new product exploration. Based on the conversations with buyers, ABC projects unit sales as follows:

|Year |Unit sales |

|1 |3,000 |

|2 |5,000 |

|3 |6,000 |

|4 |6,500 |

|5 |6,000 |

|6 |5,000 |

|7 |4,000 |

|8 |3,000 |

The new product will be priced to sell at $120 per unit to start. When the competition catches up after three years, however, ABC anticipates that the price will drop to $110.

The project will require $20,000 in net working capital at the start. Subsequently, total net working capital at the end of each year will be about 15 percent of sales for that year. The variable cost per unit is $60, and total fixed costs (not including depreciation) are $25,000 per year.

It will cost about $800,000 to buy the equipment necessary to begin production. This investment is primarily in industrial equipment, which qualifies as seven-year MACRS property. The equipment will actually be worth about $160,000 in the eighth year. The relevant tax rate is 34 percent, and the required return is 15 percent.

|MACRS |

|Year |7-Year |

|1 |14.29% |

|2 |24.49% |

|3 |17.49% |

|4 |12.49% |

|5 |8.93% |

|6 |8.93% |

|7 |8.93% |

|8 |4.45% |

Please calculate:

(1) operating cash flows every year;

(2) change in net working capital every year;

(3) capital spending in year 1 and year 8;

(4) net cash flows each year(t=0, 1, 2, ……, 8);

(5) value of this project;

(6) net present value (NPV) of this project.