Question

The Electronics Machines Corporation (EMC) is considering buying a $300,000 piece of equipment that could raise EMC’s sales revenues by $1 million the first year, $2 million the second year, and $1.8 million the third year. The cost of the piece of equipment can be fully depreciated over the three-year investment according to the straight-line method with no residual value. Incremental operating expenses are estimated at 90 percent of sales, excluding depreciation expense.
Working capital required to support the project’s sales should be 10 percent of sales with working capital investment assumed to occur at the beginning of the year. EMC can borrow at 6 percent, is subject to a 30 percent corporate tax rate, and finances 60 percent of its activities with borrowed funds. The firm uses an estimated cost of equity of 12 percent.
a. What are the project’s net present value and internal rate of return? Should the piece of equipment be purchased?
b. What is the project’s market value added? Explain why the piece of equipment should be purchased even though its first-year economic value added is negative.
c. What is the key assumption used in the estimation of the project’s cash flows and economic value added that makes the project’s net present value equal to its market value added?