Abbott Corp analyzes a capital budgeting case where the company wants to add a new product. The following information about the product is estimated by Abbott’s financial manager and passed on to you:
- Project life : 3 years
- The production would need to use currently available, existing machinery of the company. The company spent $10,000 last year to renovate this machinery (for some repainting and maintenance). If the machinery is not used for this project, Tuong An Corp. would lease it on a 5-year contract for $45,000 (after-tax) each year, starting one year from now. After 5 years of being leased, the machine would have no value to the company.
- If the company decides to use the machinery for this project, it would be depreciated according to a 3-year property MACRS schedule. At the end of the project life, it could be sold as scrap for $ 15,000.
- The project requires an initial investment in working capital of $15,000, which is fully recovered upon closure of the project
- This project is expected to generate sales of 1,450 bottles per year at a cost of $120 per bottle in the first year, excluding depreciation. Each bottle can be sold for $200 in the first year. The sales price and cost are expected to increase by 10% per year due to inflation.
- The company takes a bank loan to finance the project, and is expected to pay $2,500 as interest expense per year over the life of the project.
- The company‘s tax rate is 35%, and its overall cost of capital (WACC) is 10%.
- Please refer to this MACRS schedule for depreciation schedule:
|
Property Class |
|||
|
Year |
3-year |
5-year |
7-year |
|
1 |
33.33% |
20.00% |
14.29% |
|
2 |
44.45% |
32.00% |
24.49% |
|
3 |
14.81% |
19.20% |
17.49% |
|
4 |
7.41% |
11.52% |
12.49% |
|
5 |
11.52% |
8.93% |
|
|
6 |
5.76% |
8.92% |
|
|
7 |
8.93% |
||
|
8 |
4.46% |
||
Questions:
- What are your comments about the discount rate that could be used to discount the project cash flows?
- Is there a tax effect when selling the machinery at the end of the project life? Why is that the case?
- Calculate the project cash flows for each year
- Should Abbott Corp. invest in this project? Why?
- (bonus question) If Abbott Corp. is to consider another investment in real estate project, what is the best policy to determine the discount rate for this new investment? Any thoughts about why the company would want to invest in a different industry (other than its core business)?
