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A company manufactures athletic shoes. Two years ago, they conducted a marketing study to collect consumers' perception about new shoe designs. The study cost them $2,000,000. Today, the company is considering introducing a new shoe. The CFO has collected the following information about the proposed product.
The project has an anticipated economic life of 4 years, after that it will not be continued and will be terminated. The company will have to purchase a new machine to produce the shoes. The machine has a cost of $2 million and requires transportation and installation to the company that will cost additional $500,000. The machine will be depreciated on a straight-line basis over 4 years with 0 salvage value. The company anticipates to sell this machine to another manufacturer for $200,000 at the end of four years. If the company goes ahead with the proposed product, it will have an effect on the company's operating working capital. The inventory will increase by $150,000 and accounts payable will increase by $50,000. The shoes are expected to generate sales revenue of $1 million the first year, $2 million the second year, $2 million the third year, and $1 million the fourth year. Each year the operating costs (not including depreciation) are expected to equal 40 percent of sales revenue. The company's interest expense each year will be $500,000. The new shoes are expected to reduce the after-tax cash flows of the company's existing products by $200,000 a year over the next 4 years. The company's overall cost of capital is 12 percent. The company's tax rate is 40 percent.
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