Cash Flow Estimation Problem

YSE is a distributor of industrial equipment serving the Northeast Ohio area. The company is considering a move into manufacturing whereby it will manufacture a unique coating application machine. The company recently hired a consulting firm to collect data regarding the move under consideration.

The project will have an economic life of 5 years.

YSE will have to purchase a new machine to manufacture the new coating application machine. The machine has an up-front cost of $3 million. The machine will be depreciated on a straight-line basis for 10 years. At the end of five years, the company expects that it can sell the machine for $1 Million.

If YSE undertakes the project it will have an effect on the company's net working capital. At the outset, t=O, inventory will increase by $ 150,000 and accounts receivable will increase by %50,000. At the same time, accounts payable will increase by $30,000. At the end of the project, the net working capital will be recovered.

YSE expects the new coating application machine to generate sales of Sl million in the first year, $2 million in the second year, $2.5 million in the third year, $2 million in the fourth year and $1 million in the fifth year. Each year, operating costs will be 60% of sales. The company's annual interest expense is expected to be $ 175,000. The new coaling application machine is expected to reduce the after-tax cash flows of YSE'S division by $200,000 each year.

The company's overall WACC is 10 percent, However, based on advice from their consultant, YSE plans to adjust upward by three percent the WACC for those projects it considers "high risk" and it plans to adjust the WACC downward by 3 percent those projects it considers "low risk". The company considers the manufacturing of the new coating application machine to be "high risk".

The company's tax rate is 35 percent.

a)Determine the net cash flows that YSE can expect in each year of the project (year O year 5)

b)Use the appropriate decision rule to determine whether YSE should undertake the proposed project