Q: Harvey& Welch Company (HWC) is a rising star in the medical equipment manufacturing. In late 20X0, HWC hired Maria Mahmoud as the new CFO. Her first task is to set the financial plan and the capital budget of the new Advanced Lab Device (ALD). This device is expected to reduce the cost of hospitals significantly because it needs less time to produce reliable results at 20% less cost. The technology that will be used in the ALD was invented by HWC scientists last year and it was granted a patent at the beginning of the year. To setup the project, HWC needs to new equipment at their lab. The new equipment cost is $7.75 million, and it is depreciable on accelerated basis in 4-years to a salvage value of zero and it is expected to be salvaged at $639,000 at the end of the project. The MACRS schedule is presented in Exhibit 1.

To assess the impact of the project on the firm, Maria asked May Al-Dossary, a senior capital budgeting analyst, and Fayruz Al-Eissa, a senior demand analyst, to prepare the capital budget for the project. After assessing the demand and the competitive positioning of the firm, they came up with some estimates that will help in preparing the capital budget of the project.

The project duration is 4 years and sale price of the device is estimated to be $1,500/unit in the first year of the project. The price is expected to increase by 4% per year. In the first year, the estimated demand is 10,000 units and the demand is expected to increase by 15% per year. In terms of costs, the fixed cost of production in the first year is $2.120 million (excluding depreciation) and the variable cost is estimated to be $1,070/unit. The estimated annual change is the fixed as well as the variable cost is 3%. To get the project running, an investment in net working capital is needed. It is estimated to be 15% of next year's sales starting from year 0. The weighted average cost of capital of the project is 10% and the marginal tax rate is 40%. These estimates are shown in Exhibit 2.

After they collected the data, they had a meeting to discuss some issues related to firm value and the capital budgeting process. In the meeting, Fayruz made the following statements:

Statement 1: Choosing a positive salvage value in MACRS depreciation will lead to a higher tax saving compared to depreciating the asset to the same salvage value using straight-line depreciation.

Statement 2: Managerial resources, beside financial resources, may limit the number of projects that can be included in a firm's capital budget.

Statement 3: Similar to free cash flow to the firm (FCFF), interest expense should be added back to the net cash flow (NCF) to adjust for capital structure choices.

Statement 4: Improving the operating income by $100, CP, will increase free cash flow to firm, free cash flow to equity, and net cash flows by the same amount.

After the meeting and after finalizing the analysis, May presented the findings of the analysis to Maria so she can take finalize the decision. The executive summary of the presentation is shown below:

"By looking to the project's facts and figures, we believe that:

1. Since the technology is patented, we expect this to protect us from competition and this will help in realizing a positive net present value from the project.

2. Based on our analysis, we accept project because the NPV is positive the IRR is 13.8%. which is higher than the WACC."

b) Evaluate the three statements made by Fayruz. Clearly explain your response repeating or stating the opposite of the statement.