Project A has forecasted an outlay of $200,000 for the equipment and an additional
$40,000 for installation. The firm will see an increase of $25,000 in inventories
immediately to undertake this project, but they will also see an immediate increase in
accounts payable of $5,000. There will be a return of the net working capital change at the end of the fourth year. Also, at the end of the fourth year the firm will sell the asset for a salvage value of $25,000. The firm has a variable cost of operations that is
equivalent to 60% of sales, a sales price of $2.00 with no assumed annual inflation, and a tax rate of 26%. Depreciation will fall into the 3-year MACRS class. Unit sales are forecast to be 100,000; 110,000; 100,000; and 100,000 respectively for the first four
years.
Project B has forecasted an outlay of $176,000 for the equipment and an additional
$40,000 for installation. The firm will see an increase of $25,000 in inventories
immediately to undertake this project, but they will also see an immediate increase in
accounts payable of $25,000. There will be a return of the net working capital change at the end of the fourth year. Also, at the end of the fourth year the firm will sell the asset for a salvage value of $45,000. The firm has a variable cost of operations that is equivalent to 70% of sales, a sales price of $2.50 with no assumed annual inflation, and a tax rate of 26%. Depreciation will fall into the 3-year MACRS class. Unit sales are forecast to be 75,000; 90,000; 90,000; and 100,000 respectively for the first four years.
Please assume that (1) you will use your cash flow statement background and
understanding, (2) the original financial information provided for these two
mutually exclusive projects, and (3) ignoring any possible managerial options
from question #3. Will your project decision change if inflation in prices is 5% per
year for each of the four years? Assume, for example, that the given $2.00 price
in project A is at time 0, so the first year the price would be 5% higher. Provide
quantitative analysis and explanation. Sales will fall 3% per year for both
projects in this scenario.