Problem:
Brown Stone Corporation, maker of customized electric guitars is contemplating the investment of $1,000,000 in a new production facility. The economic life of the facility is estimated to be five years at which time the facility will be obsolete and have no salvage value. The firm will use straight-line depreciation. To make the new facility operational, improvements of $100,000 will be needed. In addition, an increase in working capital of $25,000 will be needed to start production. Brown's accounting and marketing department has provided you with the following earnings forecast. The firm is in the 30% tax bracket. In addition, the firms chief economist - a former roadie with the grateful dead - has come up with a weighted average cost of capital of 15%.
Earnings before Interest and Tax (EBIT)
Year 1 100,000
Year 2 200,000
Year 3 200,000
Year 4 200,000
Year 5 300,000
Required:
1. Calculate cash flow after tax for each year. Diagram the cash flows for the project using a time line. Indicate the initial investment, cash flow after tax, and appropriate discount rate.
2. Calculate the payback and net present value of the project.
3. Evaluate your results, is the investment a good one. What other factors would you consider before deciding to invest in the production facility?