PART: PROJECT EVALUATION

There is one particular project the firm is considering. Now that you have calculated the firm's cost of capital, you are in a position to use it to recommend to the client the acceptance or rejection of the project that is under consideration.

The project in question involves the acquisition of a new machine which will enable the firm to increase production of baby monitor machines. The firm has provided the information about this project, shown below.

Your task:

1. Determine the incremental free cash flows that would result from the acceptance of this project.

2. Calculate the NPV of the incremental free cash flows.

3. Provide the firm with your recommendation as to whether it should accept or reject this project.

Project information.

A feasibility study has been undertaken at a cost of $10, which has generated the following data.

The machine will have a useful working life of 4 years. It will cost $270 to purchase and install. This cost will be depreciated over the life of the project to a book value of zero using diminishing-value depreciation. The machine is expected to have a salvage value of $32, which will be received in Year 5.

The project will require an increase in net working capital of $16, which will be recovered in Year 5, after the machine is disposed of.

The new machine will generate increased revenue of $142 in its first year of operation. However, due to increased wear and tear, the output of the machine, and hence the level of additional revenue, in Years 2, 3 and 4, will decrease each year by 3% from the previous year.

Use of the new machine will require an additional $30 per year in wages. It will also incur additional maintenance costs of $9 in the first year. Because of additional wear and tear, this maintenance cost will then increase by $2 per year for the remaining life of the machine.

The machine will be installed in a building already owned by the firm. If this project does not go ahead, this building could be rented out for $16 per year.