Healthy Foods Company (HFC) currently processes seafood with a unit it purchased several years ago. The unit, which originally cost $500,000, has a current book value of $250,000. HFC is considering replacing the existing unit with a newer, more efficient one. The new unit will cost $750,000 and will also require an initial increase in net working capital of $40,000. The new unit will be depreciated on a straight‐line basis over five years to a zero balance. The existing unit is being depreciated at a rate of $50,000 per year. HFC expects to sell the existing machine today for $275,000. HFC’s tax rate is 30%.
If HFC purchases the new unit, annual revenues are expected to increase by $100,000 (due to increased capacity), and annual operating costs (exclusive of depreciation) are expected to decrease by $20,000. Annual revenues and operating costs are expected to remain constant at this new level over the five‐year life of the project. Accumulated net working capital will be recovered at the end of five years.
HFC’s (Simplified) Balance sheet is below:
|Assets Liabilities & Equity|
HFC’s equity beta is 1.3, cost of debt is 10% and the risk‐free rate and market return are 8% and 14% respectively.
Answer the following
- Calculate the project’s initial net investment.
- Calculate the annual net operating cash flows for the project.
- Calculate HFC’s cost of equity and weighted average cost of capital.
- Should HFC proceed with the project? Why?
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