The Johnson Chemical Company has justreceived a special subcontracting job from one of itsclients. The two-year project requires the purchaseof a special-purpose painting sprayer of $60,000.This equipment falls into the MACRS five-yearclass. After the subcontracting work is completed,the painting sprayer will be sold at the end of twoyears for $40,000 (actual dollars). The painting system will require an increase of $5,000 in net working capital (for spare-parts inventory, such as spraynozzles). This investment in working capital will befully recovered after the project is terminated. Theproject will bring in an additional annual revenueof $120,000 (today’s dollars), but it is expected toincur an additional annual operating cost of $60,000(today’s dollars). It is projected that, due to inflation, sales prices will increase at an annual rate of5%. (This implies that annual revenues will increaseat an annual rate of 5%.) An annual increase of 4%for expenses and working-capital requirement isexpected. The company has a marginal tax rate of30%, and it uses a market interest rate of 15% forproject evaluation during the inflationary period. Thefirm expects a general inflation of 8% during the project period.(a) Compute the after-tax cash flows in actualdollars.(b) What is the rate of return on this investment (realearnings)?(c) Is the special subcontracting project profitable?
The Johnson Chemical Company has just
received a special subcontracting job from one of its
clients. The two-year project requires the purchase
of a special-purpose painting sprayer of $60,000.
This equipment falls into the MACRS five-year
class. After the subcontracting work is completed,
the painting sprayer will be sold at the end of two
years for $40,000 (actual dollars). The painting system will require an increase of $5,000 in net working capital (for spare-parts inventory, such as spray
nozzles). This investment in working capital will be
fully recovered after the project is terminated. The
project will bring in an additional annual revenue
of $120,000 (today’s dollars), but it is expected to
incur an additional annual operating cost of $60,000
(today’s dollars). It is projected that, due to inflation, sales prices will increase at an annual rate of
5%. (This implies that annual revenues will increase
at an annual rate of 5%.) An annual increase of 4%
for expenses and working-capital requirement is
expected. The company has a marginal tax rate of
30%, and it uses a market interest rate of 15% for
project evaluation during the inflationary period. The
firm expects a general inflation of 8% during the project period.
(a) Compute the after-tax cash flows in actual
dollars.
(b) What is the rate of
earnings)?
(c) Is the special subcontracting project profitable?
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