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8. After spending $10,000 on client development, you have just been offered a big production contract by a new client. The contract will add $200,000 to your revenues for each of the next 5 years and it will cost you $100,000 per year to make the additional product. You will have to liquidate existing equipment and buy new equipment as well. The existing equipment is fully depreciated but could be sold for $50,000 now. You will buy new equipment valued at $30,000 and use the 5-year MACRS schedule to depreciate it. It will be worthless at the end of the project. Your current production manager earns $80,000 per year. Since she is busy with ongoing projects, you are planning to hire an assistant at $40,000 per year to help with the expansion. You will have to increase your inventory immediately from $20,000 to $30,000. It will return to $20,000 at the end of the project. Your companys tax rate is 35% and your discount rate is 15%. What is the NPV of the contract? (Answer: $135,452.5) (Hints: The $10,000 on client development has already happened in the past and thus should NOT affect our replacement decision. Our replacement decision depends only on future expected incremental free cash flows resulting from the decision. The costs resulting from past decisions are called sunk costs and are irrelevant to current replacement decision. The salary of current production manager ($80,000) is also considered a sunk cost and is irrelevant information. Assume that we liquidate existing equipment and purchase new equipment in year 0 but put new equipment into work in year 1.)

Year	0	1	2	3	4	5	6
New equipment cost
MACRS depreciation schedule		20%	32%	19.20%	11.52%	11.52%	5.76%
Depreciation expenses

Year	W/O project	0	1	2	3	4	5
Level of NWC
Change in NWC
Subtract change in NWC

Year	0	1	2	3	4	5	6
Revenues
Costs
Gross Profit
Selling, general, and administrative (e.g., salary of a new assistant)
Depreciation
EBIT
Tax (35%)
Incremental Earnings
Add back depreciation
Capital expenditure
Subtract change in NWC
Salvage cash flow
Incremental FCF

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