The Delaware Chemical Corporation is considering investing in a new composite material. R&D engineers are investigating exotic metal-ceramic and ceramic-ceramic composites to develop materials that will withstand high temperatures, such as those to be encountered in the next generation of jet fighter engines. The company expects a three-year R&D period before these new materials can be applied to commercial products. The following financial information is presented for management review.
• R&D cost: $5 million over a three-year period: $0.5 million at the beginning of year 1, $2.5 million at the beginning of year 2, and $2 million at the beginning of year 3. For tax purposes, these R&D expenditures will be expensed rather than amortized.
• Capital investment: $5 million at the beginning of year 4. This investment consists of $2 million in a building and $3 million in plant equipment. The company already owns a piece of land as the building site.
• Depreciation method: The building (39-year real property class with the asset placed in service in January) and plant equipment (seven-year MACRS recovery class).
• Project life: 10 years after a three-year R&D period.
• Salvage value: 10% of the initial capital investment for the equipment and 50% for the building (at the end of the project life).
Total sales: $50 million (at the end of year 4), with an annual sales growth rate of 10% per year (compound growth) during the next five years (year 5 through year 9) and -10% (negative compound growth) per year for the remaining project life.
Out-of-pocket expenditures: 80% of annual sales.
Working capital: 10% of annual sales (considered as an investment at the beginning of each production year and investments fully recovered at the end of the project life).
Marginal tax rate: 40%.
(a) Determine the net after-tax cash flows over the project life,
(b) Determine the IRR for this investment.
(c) Determine the equivalent annual worth for the investment at MARR = 20%.