You are asked to evaluate a 2-year project that requires the acquisition of an equipment. The (22%) equipment costs $750,000, and falls into the MACRS 7 year class. The equipment will be sold after TWO years for 55% of its purchase price. The initial (at t=0) net working capital (NWC) requirement is 8% of the equipment cost. The project will increase the firms annual revenues and annual operating costs by $420,000 and $140,000, respectively, in Year 1. Afterwards, annual revenues and annual operating costs will grow at nominal rates of 5% and 4%, respectively, over the life of the project. The NWC requirement is expected to grow at the inflation rate of 3% annually. In addition, you conducted a $100,000 pilot study for the project last year. The firm's average and marginal tax rates are, respectively, 32.4% and 34.0%. The nominal discount rate is 14% (a) Compute the initial cash flow of the project. (b) Compute the annual total cash flows during the life of the project. Note that the project will be terminated at the end of Year 2. (c) What is your recommendation on this project according to the conceptually most correct capital budgeting method? Justify your recommendation with the related calculations! (d) Use the Fisher Equation to compute the real discount rate. Would the NPV be overstated/understated (select one) if you mistakenly used the real discount rate to discount the (nominal) total cash flows of the project?

MACRS Table

YEAR 3-year 5-year 7-year

1 33.33% 20.00% 14.29%

2 44.45 32.00 24.49

3 14.81 19.20 17.49

4 7.41 11.52 12.49

5 11.52 8.93

6 5.76 8.92

7 8.93

8 4.46