Question

Your firm is looking into offering a new product. This new project will run for only five years.

To produce this new product, you will need new equipment, which will cost $2,200,000 base cost, with shipping and installation costing another $35,000.

Your research has led you to believe that you can sell 85,000 units per year for $21.50 per bag. The cost of the contents, packaging and shipping are expected to be $8.15 per bag. The annual fixed costs of the venture are expected to be $350,000. For simplicity, we will assume that the cost of the project will be 100 percent depreciated over the five-year life of the project. Furthermore, the cost of removing the equipment will approximate the market value at the end of the project, so it will essentially be worthless on the books and in actuality. We will assume a tax rate of 40%.

It is believed that as a result of this project that inventory will have to increase by $71,750, accounts receivable will increase by $35,875, and accounts payable will increase by $35,125.

Using the cost of capital in your firm (10%), should you invest in the new project? Why?

Answer 1

Here, total new investment needed = cost of new equipment + cost of installation + increase in working capital

= 2200000 + 35000 + 71750 + 35875 - 35125

= 2307500

annual sales	85000 * 21.5	1827500
Less : COGS	85000 * 8.15	( 692750 )
Less : annual fixed cost		( 350000 )
Less : Cost of capital	2307500@ 10 %	( 230750 )
Total		554000
Less : Tax	@40 %	( 221600 )
annual profit		332400
Total profit of venture	Annual profit * 5	1662000

Since the Assets will be 100% depreciated in these 5 years and the returns are less as compaired to capital invested , it will not be suitable to invest in this venture

Note : It has been assumed that the capital consists of borrowed funds and thus, the cost of capital will be subtracted before payment of tax.

also, if we assume the capital to be owners capital and not borrowed from outsiders, then also the returns on the investment are very low and thus it will not be suitable to invest.