K&G Chemical Company has just received a special subcontracting job from one of its clients. This two‐year project requires the purchase of a special‐purpose painting sprayer for $60,000. This equipment falls into the MACRS five‐year class. After the subcontracting work is completed at the end of two years, the painting sprayer will be sold for $40,000 (actual dollars). The painting system will require an increase in the company’s net working capital (for spare‐parts inventory, such as spray nozzles) of $5,000. This investment in working capital will be fully recovered at the project termination. The project will bring in an additional annual revenue of $120,000 (today’s dollars), but it is expected to incur an additional annual operating cost of $60,000 (today’s dollars). It is projected that, because of inflation, there will be sales‐price increases at an annual rate of 5%, which implies that annual revenues will also increase at an annual rate of 5%. An annual increase of 4% for expenses and working‐capital requirements is expected. The company has a marginal tax rate of 30%, and it uses a market interest rate of 15% for project evaluation during the inflationary period. The firm expects a general inflation of 8% during the project period.
(a) Compute the after‐tax cash flows in actual dollars.
(b) What is the rate of return on this investment (real earnings)?
(c) Is this special order profitable?