Question

Consider a firm having an opportunity to produce a product with a life cycle of 5 years. The Expected sales for the project are $100,000 per year at the end of each of the next 5 years. The before-tax profit margin on each dollar of sales is 10 percent. The firm has a marginal tax rate of 40 percent and a required rate of return of 15 percent. The production of the product in question will require the purchase of machinery at a cost of $10,000. The machinery can be depreciated over 5 years using straight line depreciation. In addition, the project will require an investment in inventories and accounts receivables which may reasonably be expected to be recovered at the end of 5 years, when the project terminates. Although the required investment in inventory and receivables is not known at the present time, the industry standards for inventory turnover and accounts receivable turnover are respectively 6 times per year and 12 times per year. The upside for sales is $120000 and the downside is $80000 per year. There is a 30% probability for the downside and 20% probability for the upside. Is this a good investment? Please justify your answer.

Answer 1