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Cleveland Enterprises is considering the addition of a new product line. The firm would not need…

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Cleveland Enterprises is considering the addition of a new product line. The firm would not need additional factory space, but it would require the purchase of $2.85 million of equipment installed. The equipment would be depreciated using a 7-year accelerated depreciation schedule. Additional inventory of 10% of the first year’s sales would be necessary, but the entire value will be recovered at the end of the project. The firm expects to sell 350,000 units during the first year of the project, increasing to 375,000 units during the next three years before decreasing to 100,000 during the fifth and final year of the project. The product is expected to be obsolete at that point. The expected sales price is $12 per unit with a variable cost of $6 per unit during the first year of operations. Variable costs will increase by 5% per year, but the sales price remains fixed. Fixed costs are estimated at $580,000 during the first year, but will increase by 6% per year. The firm’s tax rate is 21%. The equipment has an estimated salvage value of $500,000.

What is the estimated net present value of the project assuming a required return of 16%?

Management of the firm is concerned the economy is potentially entering a recession, which would decrease the demand for the product to an estimated 100,000 units for all 5 years and force the firm to drop the price to $9.

What is the estimated net present value of the project assuming a recession?

Based on your calculations, what recommendations would you make to the management of Cleveland Enterprises?

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