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Question
A firm believes it can generate an additional $250,000 per year in revenues for the next 5 years if it replaces existing equipment that is no longer usable with new equipment that costs $240,000. The firm expects to be able to sell the new equipment when it is finished using it (after 5 years) for $10,000. The existing equipment has a book value of $20,000 and a market value of $12,000. Variable costs are expected to total 70% of revenue. The additional sales will require an initial investment in net working capital of $15,000, which is expected to be recovered at the end of the project (after 5 years). Assume the firm uses straight line depreciation, its marginal tax rate is 30%, and its weighted-average cost of capital is 10%.
a) How much value will this new equipment create for the firm?
b) At what discount rate will this project break even?
c) Should the firm purchase the new equipment?
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