Question

Stanton Stax wants to add a new assembly line. This addition will expand capacity, resulting in the firm receiving incremental cash flows of $35,000 per year for the next four years. At the end of the fourth year. Stanton will sell the equipment for this line for $10,000. The purchase price of the equipment is $100,000. At what cost of capital (required return) is Stanton indifferent between investing and not investing in the new assembly line? At what cost of capital should Stanton make the investment?

Answer 1

To determine the cost of capital at which Stanton Stax is indifferent between investing and not investing in the new assembly line, calculate the NPV of the project and compare it to zero. Stanton should make the investment if the NPV is positive. To find the cost of capital at which Stanton should make the investment, calculate the IRR of the project.

Step-by-step explanation:

To determine the cost of capital at which Stanton Stax is indifferent between investing and not investing in the new assembly line, we need to calculate the net present value (NPV) of the project. The NPV is the sum of the present values of all the cash flows associated with the investment. In this case, we have incremental cash flows of $35,000 per year for 4 years, and $10,000 from selling the equipment at the end of the 4th year. The purchase price of the equipment is $100,000.

1. First, discount the cash flows to their present values using the cost of capital (required return). For example, if the cost of capital is 10%, the present value of $35,000 in the first year would be $35,000 / (1 + 0.10)^1 = $31,818.18.
2. Next, sum up all the present values of the cash flows to get the NPV. If the NPV is positive, it means the investment is profitable. If the NPV is negative, it means the investment is not profitable.
3. To find the cost of capital at which Stanton should make the investment, we need to calculate the internal rate of return (IRR) of the investment. The IRR is the discount rate at which the NPV is zero. We can use trial and error or financial calculators/software to find the IRR.

In conclusion, to determine the cost of capital at which Stanton Stax is indifferent between investing and not investing in the new assembly line, we need to calculate the NPV of the project. Stanton should make the investment if the NPV is positive. To determine the cost of capital at which Stanton should make the investment, we need to calculate the IRR of the project.