Apple Jacks, Inc., produces wine. The firm is considering expanding into the snack food business. This expansion will require an initial investment in new equipment of $200,000. The equipment will be depreciated on a straight-line basis over a 10-year period to zero.
At the end of the project the equipment is estimated to have a salvage value of $50,000. The expansion will also require an increase in working capital for the firm of $40,000. Revenues from the new venture are forecasted at $200,000 per year for the first 5 years and $210,000 per year for years 6 through 10. Operating costs exclusive of depreciation from the new venture are estimated at $90,000 for the first 5 years and $105,000 for years 6 through 10. It is assumed that at the end of year 10, the snack food equipment will be sold for its estimated salvage value. The firm’s marginal tax rate is 40 percent. The required return for projects of average risk has been estimated at 15 percent.
a. Compute the project’s net present value, assuming that it is an average-risk investment.
b. If management decides that all product line expansions have above-average risk and therefore should be evaluated at a 24 percent required rate of return, what will be the risk-adjusted net present value of the project?