Finance: Capital budgeting explained
A manufacturing company is thinking of launching a new
product. The company expects to sell $950,000 of the new product in the first
year and $1,500,000 each year thereafter. Direct costs including labor and
materials will be 55% of sales. Indirect incremental costs are estimated at
$80,000 a year. The project requires a new plant that will cost a total of
$1,000,000, which will be a depreciated straight line over the next 5 years.
The new line will also require an additional net investment in inventory and
receivables in the amount of $200,000.
Assume there is no need for additional investment in
building the land for the project. The firm’s marginal tax rate is 35%, and its
cost of capital is 10%.
– Prepare a statement showing the incremental cash flows for
this project over an 8-year period.
– Calculate the payback period (P/B) and the net present
value (NPV) for the project.
– Answer the following questions based on your P/B and NPV
calculations:
– Do you think the project should be accepted? Why?
– Assume the company has a P/B (payback) policy of not
accepting projects with life of over 3 years.
– If the project required additional investment in land and
building, how would this affect your decision? Explain
