Morgan company is considering expanding its production capacity by purchasing a new machine, the AC250. The cost of the AC250 is $1 million. Unfortunately, installing this machine will take several months and will partially disrupt production. The firm has just completed a $45,000 feasibility study to analyze the decision to buy the AC250, resulting in the following estimates:

Marketing: Once the AC250 is operating next year, the extra capacity is expected to generate $10 million per year in additional sales, which will continue for the 5-year life of the machine.

Operations: The disruption caused by the installation will decrease sales by $5 million this year. Once the machine is operating next year, the cost of goods for the products produced by the AC250 is expected to be 50% of their sale price.

Human Resources: The expansion will require additional sales and administrative personnel at a cost of $0.4 million per year.

Accounting: The AC250 will be depreciated via the straight-line method over the 5-year life of the machine. The firm expects receivables from the new sales to be 20% of revenues and payables to be 10% of the cost of goods sold. The increased production will require additional inventory on hand of $1.2 million to be added in year 0 and depleted in year 5.

Morgan companys marginal corporate tax rate is 20%. The appropriate cost of capital for the expansion is 9.9%.

Required

Assume you are financial consultant of Morgan company. Draft a report to Alex (Financial controller), and answer the following questions:

(a)Discuss why computing a projects effect on the companys earnings insufficient for capital budgeting?

(b)Determine the annual depreciation tax shield from the purchase of the AC250, and explain how the tax shield impact on the Free Cash Flow?

300-400 words Please