The Ucan Corporation is considering investing in a new packaging business using recycled paper. To investigate the feasibility of using recycled paper, the company spent $100,000 in the research and development of this new packaging material. If the company decides to invest in this new project, it will require the purchase of a new packaging machine for $1 million. The installation cost of the machine is $50,000. The packaging machine has an estimated economic life of three years and will be depreciated straight line over two-year to a zero book value. The packaging operation will be housed in a vacant plant where the Ucan Corporation bought for $200,000 ten years ago. Currently the book value of the plant is zero and it has been vacant since last year. The company plans to rent it out and has just received an offer for a three-year lease at an annual rental fee of $50,000. To finance this new packaging project, the Ucan Corporation plans to borrow $200,000 bank loan at an interest rate of 6%. It also plans to pay out 50% of its net income from this new packaging project as dividends to its shareholders annually.

The packaging business is expected to generate annual sales of $6 million during the economic life of the machine. The cost of goods sold is expected to be 50% of sales. Marketing and administrative expenses are expected to be 20% of sales. However, once the new recycled paper packaging business is introduced, this project is likely to decrease the sales of Ucan Corporations existing plastic packaging business by $800,000 annually and its associated production costs by $500,000 annually.

The new project will also have requirements in various net working capital accounts. It is estimated that once the project is in operation, the Ucan Corporation needs to hold 4% of its annual sales in cash, 5% of its annual sales in accounts receivable, 8% of its annual sales in inventory, and 6% of its annual sales in accounts payable. The net working capital will be fully recovered at the end of the project.

The firm is in the 35% tax bracket, and has a cost of capital of 10%.

A. Compute the following of the Ucan Corporation's new packaging project:

the required net working capital in the first year (3 marks)

the initial incremental free cash flow at year zero (2 marks)

the incremental earnings (unlevered net income) at the end of year one (4 marks)

the incremental free cash flow at the end of year one (4 marks)

the terminal free cash flow at the end of the project (4 marks)

B. Should you include the following cash flows in analyzing the Ucan Corporation's new packaging project? Justify your answer with a brief comment on the relevance of the cash flow.

$100,000 spent in the research and development of this new packaging material (2 marks)

annual rental fee of $50,000 of the plant (2 marks)

6% interest cost on the $200,000 loan (2 marks)

C. Suppose the Ucan Corporation has to shut down the project after two years unexpectedly. Assume the salvage value of the packaging machine is $650,000 at the end of year two. Compute the after-tax cash flow from sale of the machine. (2 marks)

D. Holding everything else the same, if the Ucan Corporation moves into a higher tax bracket, will it affect this replacement projects NPV? Explain your answer briefly in one sentence. (2 marks)