Big Muzz Motors manufactures a line of traditional (two wheel) motor cycles. Given the recent success of moto-cars like the Polaris slingshot, management is considering a new business proposal to produce a line of aggressive 3-wheeled motorcycles. Estimates of the cost and benefits include the following information:

Cost of new production equipment and machinery including freight and setup $2,000,000 with a 5 year life (assume straight line depreciation applies)

Expense of hiring and training new employees pre-startup $125,000

Pre-start-up advertising and other miscellaneous expenses $75,000

Initial inventory required to service sales $150,000 at t0 (does not vary over the life of the project will be sold off at end of project). This is the only working capital for this project.

Sales are forecast to be 125 units the first year and will grow 35% in the second year and 20% in the third.

Sales Price: $24,000 / unit

Unit cost to manufacture (60% of revenue): $14,400

Additional selling and administrative expense per year after start-up 12% of sales

If Big Muzz does this project to make three-wheeled car alternatives they expect to lose some of their current motorcycle sales to the new product. Ten percent of the new unit forecast is expected to come out of sales that would have gone to the old line of motorcyles (e.g. someone comes in to buy a motorcycle but sees the new product and decides to buy one of them instead). You can assume that prices and profit margins are identical for both product lines.

Make sure that you remember that this project is part of an existing company and so any tax savings on losses could be used to offset taxes on other lines of business. Assume that these tax savings can be fully absorbed in the year they are incurred.

Big Muzz has a 35% tax rate and wants to estimate the cash flows of this project over the next 3 years. Assume that the initial inventory is liquidated at its current value at the end of three years and that the new equipment purchased today is sold at its book value in 3 years.

QUESTION: If Big Muzz thought they could earn 12% on other investments, would you recommend they do this project? Why or why not?