S & P Corporation (SPC) is considering entering a new line of business. In analyzing the potential business, the financial staff has accumulated the following information: The new business will require a capital expenditure of $5.5 million at t = 0. This expenditure will be used to purchase new equipment. This equipment will be depreciated according to MACRS five-year class (see table next page). The equipment will have a salvage value of $500,000 after five years. If SPC goes ahead with the new business, inventories will rise by $300,000 whereas accounts payable will rise by $200,000 (both at t = 0). As a matter of fact, the required level of working capital is 2.5% of expected sales over the year: WCt = 2.5%*Salest+1 The new business is expected to have an economic life of five years. The Marketing Department forecasts to sell 300,000 units during the first year and then 400,000 units thereafter. The expected price is $10 per unit during the first year. Price must be adjusted by inflation in subsequent years. During the first year, variable cost is expected to be $5.50 per unit whereas fixed cost is $100,000. These figures must be adjusted by inflation in subsequent years. The new product is expected to increase before-tax cash flows of the companys existing products by $300,000 per year in real terms. This amount also has to be adjusted by inflation. The expected inflation rate during the life of the project is 2% per year. The companys interest expense each year will be $220,000. The companys tax rate is 40%. The company is very profitable, so any accounting losses on this project can be used to reduce the companys overall tax burden. The companys cost of capital (WACC) is 6.80%. However, the proposed project is riskier than the average project for SPC and therefore you have to add 2% to the corporate cost of capital. The companys CFO wants you to analyze the project and to write a short report with your recommendation. Please be advised that the report will be read by both financial and non-financial managers, therefore, make sure you explain your calculations and recommendation. MACRS 5-year class Depreciation Year Rates 1 0.20 2 0.32 3 0.19 4 0.12 5 0.11 6 0.06