As a financial analyst, you have been hired by Paperworks Inc. to evaluate a proposed project for the production of printer cartridges and make a recommendation to the board of directors based on capital budgeting techniques. Below is the relevant information compiled by the company:

1. The required equipment would cost $110,000 with additional $20,000 for shipping and installation.
2. The project will last for three years.
3. Accounts payable plus accruals would increase by $5,000 in Year 0.
4. Accounts receivables will increase by $6,000 and inventories will increase by $9,000 in Year 0.
5. Fixed costs excluding depreciation is $15,000 each year.
6. The equipment will be depreciated under MACRS with a 3-year life (i.e 33%, 45%, 15% and 7%).
7. When the project is over in three years, the company expects to sell the equipment for $30,000.
8. The Net Working Capital will be fully recovered at the end of the project.
9. Paperworks federal-plus-state tax rate is 35%.
10. The company believes it will sell 12,000 units the first year, 10,000 units the second year and 20,000 units the third year.
11. The price per unit is $10.
12. The associated variable cost is estimated at $3 per unit which will increase by 10% each year.

Weighted Average Cost of Capital (WACC):

Paperworks common stock sells at $50 per share; new preferred stock sells for $65 per share and pays dividends of $10. Last year, the company paid dividends of $2.60 per share on common stock which is expected to grow at a constant rate of 7%. Flotation cost for common and preferred stock is 10% of the price. The interest rate on debt is 16%. The companys optimum target capital structure is:

Common equity 60%

Preferred 15%

Debt 25%

Your main task is to compute the WACC, estimate the cash flows and use all six capital budgeting techniques to evaluate the project. You will have to present your recommendations stating whether the company should undertake or reject the project.

Questions

To help in the analysis, answer all the following questions:

1. What is the total investment amount at the start of the project (i.e. year zero cash flow)?

2. What is the depreciation amount for each year?

• Create a depreciation schedule

3. Compute the Net Income during the projects life.

4. What are the projected Operating Cash Flows (OCF)?

• OCF = EBIT + DEPRECIATION - TAXES