(Determining relevant cash flows) Landcruisers Plus (LP) has operated an online retail store selling off-road truck parts. As the name implies, the firm specializes in parts for the venerable Toyota FJ40, which is known throughout the world for its durability and off-road prowess. The fact that Toyota stopped building and exporting the FJ40 to the U.S. market in 1982 meant that FJ40 owners depended more and more on remanufactured parts to keep their beloved off-road vehicles running. More and more FJ40 owners are replacing the original inline six-cylinder engines with a modern American-built engine. The engine replacement requires mating the new engine with the Toyota drive train. LP’s owners had been offering engine adaptor kits for some time but have recently decided to begin building their own units. To make the adaptor kits, the firm would need to invest in a variety of machine tools costing a total of $700,000.

LP’s management estimates that the company will be able to borrow $400,000 from its bank and pay 8 percent interest. The remaining funds would have to be supplied by LP’s owners. The firm estimates that it will be able to sell 1,000 units a year for

$1,300 each. The units would cost $1,000 each in cash expenses to produce (this does not include depreciation expense of $70,000 per year or interest expense of

$32,000). After all expenses, the firm expects earnings before interest and taxes of

$198,000. The firm pays taxes equal to 30 percent, which results in net income of

$138,600 per year over the 10-year expected life of the equipment.

a. What is the annual free cash flow LP should expect to receive from the investment in Year 1, assuming that it does not require any other investments in either capital equipment or working capital and that the equipment is depreciated over a 10-year life to a zero salvage and book value? How should the financing cost associated with the $400,000 loan be incorporated into the analysis of cash flow?

b. If the firm’s required rate of return for its investments is 10 percent and the investment has a 10-year expected life, what is the anticipated NPV of the investment?