Solomons Electronics Company is considering adding a new line to its product mix, and the capital budgeting analysis is being conducted by JB, a recently graduated BBA.

The production line would be set up in unused space in Solomons' main plant. The machinerys invoice price would be approximately $175,000, another $9,000 in shipping charges would be required, and it would cost an additional $20,000 to install the equipment. The machinery has an economic life of 4 years, and Solomons has obtained a special tax ruling that places the equipment in the MACRS 3-year class. The machinery is expected to have a salvage value of $20,000 after 4 years of use.

The new line would generate incremental sales of 1,150 units per year for 4 years at an incremental cost of $105 per unit in the first year, excluding depreciation. Each unit can be sold for $195 in the first year. The sales price and cost are both expected to increase by 2% per year due to inflation. Further, to handle the new line, the firms net working capital would have to increase by an amount equal to 11% of sales revenues. The firms tax rate is 35%, and its overall weighted average cost of capital, which is the risk-adjusted cost of capital for an average project (r), is 9%.

(2.) Solomons typically adds or subtracts 2.7 percentage points to the overall cost of capital to adjust for risk. Should the new line be accepted?

Cost of capital for average projects:

Answer:

Adjustment for risky projects:

Risk adjusted cost of capital:

NPV with risk-adjusted cost of capital: