The Capital Investment Decision You are hired to replace the assistant manager who had prepared the companys capital investment for its Aerospace. Your boss comes into your office and drops the report of capital investment that was prepared by the assistant manager. You open the report, and you find out the following estimates:

You noticed the depreciation is estimated using a straight line and you wonder if maybe MACRS would have been better. The report also indicates that the project is not profitable since its net income is negative. You think back to your finance classes and realize the mistakes that are made in this report.

First, you note that the assistant manager did not factor in that the project will require a $10,000 investment in the net working capital upfront (year 0), which will be fully recovered at the end of 6 years. Next, you see they have attributed $3,000 of selling, general, and administrative expenses to the project, but you know that $1,000 of this amount is overhead that will be incurred even if the project is not accepted. Finally, you know that accounting earnings are not the right thing to focus on! Capps Supply is a private unlevered company. The company does not know its cost of capital and as result, you need to come up with the cost of capital to evaluate the project. You also remember in your finance classes that you could estimate the cost of capital by using the security market line (SML). To calculate the SML you need to have the beta, risk-free rate, and market risk premium. You check the internet, and you find out the 30-years treasury bond rate is about 3% and the market risk premium is 8 percent.

1. Given the available information, what are the free cash flows in years 0 through 6 that should be used to evaluate the proposed project?

\begin{tabular}{|l|r|} \hline Equipment cost & $45,000 \\ \hline Sales & $40,000 \\ \hline Cost of goods sold & $30,000 \\ \hline Gross profit & $10,000 \\ \hline General, S\&A & $3,000 \\ \hline Depreciation & $7,500 \\ \hline Net operating income & $500 \\ \hline Income tax & $125 \\ \hline Net income & $375 \\ \hline \end{tabular} \begin{tabular}{|l|r|} \hline Equipment cost & $45,000 \\ \hline Sales & $40,000 \\ \hline Cost of goods sold & $30,000 \\ \hline Gross profit & $10,000 \\ \hline General, S\&A & $3,000 \\ \hline Depreciation & $7,500 \\ \hline Net operating income & $500 \\ \hline Income tax & $125 \\ \hline Net income & $375 \\ \hline \end{tabular}