Your firm is considering a capital budgeting proposal to manufacture keypads for tablet devices. The project is anticipated to have a useful life of 10 years. You estimate that revenues associated with this project will be $15M per year. The cost of goods sold (including depreciation of the new equipment discussed below) for the new keyboards is expected to be $8M per year. Direct selling and administrative expenses associated with the project are expected to be $3.2M per year. If you undertake the project, your firm expects to lose $2.2M in EBIT from other product lines. Additional inventory required for the project is projected to follow the schedule below.
Your firm assesses a charge of $0.10 per dollar of revenue to all new projects to cover the cost of overhead (i.e. the building, the CEO’s salary etc.) at the corporate headquarters. The firm will have to make an initial investment today of $7M in capital expenditures for this project. This investment will be depreciated on a straight line basis over 10 years to a final book value of zero and is the only equipment that is necessary for the project. You anticipate that the (pre-tax) market value of this equipment in 10 years will be $1M. You may assume that cash flows are received annually, and that the first cash flow is generated one year from today. Also, please note that any gain (or loss) on the sale of the equipment is taxable (or tax deductible) at the corporate tax rate. The tax rate is 35%. The beta of the project is 1.2. The market risk premium is 4% and the risk free rate is 5%. The firm’s WACC is 7.2%.
a.) What is the appropriate discount rate for this project?
b.) What is the NPV of the project?
c.) A colleague argues that the project should not be taken because it is risky and the firm can’t afford to take risks in a bad economy. Is she right? Why or why not?