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Oilfield Automation Inc. (OAI) produces specialized equipment to aid in the drilling of oil and gas wells. The company is evaluating the expansion of its

Oilfield Automation Inc. (OAI) produces specialized equipment to aid in the drilling of oil and gas wells. The company is evaluating the expansion of its manufacturing plant to enable it to take on a new customer group for the next 5 years. Last year, the company spent $25,000 to do marketing research analysis to estimate market demand for new customer segments. The current expansion scenario would have total construction costs of $900 thousand and it would take about 60 days to complete (i.e., essentially up-front). It would also put in $250 thousand of new machinery and equipment. Inventory (raw materials, work-in-process, finished goods) investment needed for the expansion to get started would be $125 thousand. Except for the inventory investment, the total upfront investment can be depreciated using the straight-line method over four years, but the company has decided for income tax purposes to expense 100% of the cost of the long-term assets in Year 0. The company expects to incur $72 thousand in incremental annual interest expense, and the company expects it could increase annual dividends $0.10 per share (there are 400,000 shares outstanding). Incremental sales for this project are based on forecast demand of 25 units in the first year, 35 units in the second year, 53 units in the third year, 36 units in the fourth year, and 15 units in the fifth year, with an average selling price of $35,000 per unit. Cost of goods sold is estimated to be 60% of total sales each year, and incremental fixed costs are estimated to be $90,000 per year. At the end of the projects estimated life, the company estimates it could sell the purchased machinery and equipment for $250,000 and the expected the book value for these items would be zero. Also, at the end of the project, $30,000 of inventory could be liquidated (with no income tax effect). OAIs assumed marginal income tax rate is expected to be 25% for ordinary income and 25% for capital gains income. If OAI does this project, it will immediately sell some existing surplus equipment for a price of $320,000 which has a current book value of $150,000 and which has future depreciation of $50,000 for the next three years. OAIs weighted average cost of capital is 10%, so it believes this project should earn at least 12% average annual return.

  1. What is the Total Free Cash Flow for Year 4 and Year 5?

  2. What is the Terminal Year-Specific Non-Operating Total Free Cash Flow?

  3. Are there any Sunk Costs?

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