In: Finance
Blue Buffalo has a new 4-year project to evaluate. The Installed Cost of the project’s long-term assets is $200 million. The project also requires an initial Net Working Capital increase of $30 million (no further changes in NWC are required) when implemented at t=0. This initial Net Working Capital of $30 million is also assumed to be fully recovered when the project is terminated at t=4 years. The project’s assets fit into a 3 year IRS MACRS depreciation schedule as follows: Year 1 -- 33%; Year 2 -- 45%; Year 3 -- 15%; Year 4 -- 7%. The project will be terminated exactly four years from today (t=4) and this project’s assets will then be sold at an estimated $40 million salvage value. If the project is accepted it will increase the firm’s revenue and operating costs by $110 million and $40 million, respectively, for each of the following four years (t=1 through t=4). The corporate tax rate is 40%. The cost of capital for this project is r=12% per year. This is a stand alone project. Calculate the NPV and IRR. Should this project be accepted or rejected?
Formula | Year (n) | 0 | 1 | 2 | 3 | 4 |
Initial investment (II) | 200 | |||||
Revenue increase ('R) | 110 | 110 | 110 | 110 | ||
Op.cost increase (OC) | 40 | 40 | 40 | 40 | ||
3-year MACRS dep. Schedule | Depreciation rate ('r) | 33% | 45% | 15% | 7% | |
II*r | Depreciation (D) | 66 | 90 | 30 | 14 | |
R-OC-D | EBIT | 4 | (20) | 40 | 56 | |
EBIT*(1-Tax rate) | After-tax EBIT | 2 | (12) | 24 | 34 | |
Add: depreciation (D) | 66 | 90 | 30 | 14 | ||
After-tax EBIT + D | Operating Cash Flow (OCF) | 68 | 78 | 54 | 48 | |
NWC change | (30) | 30 | ||||
salvage value*(1-Tax rate) | After-tax salvage value (SV) | 18 | ||||
SV + NWC + FCF - II | Free Cash Flow (FCF) | (230) | 68 | 78 | 54 | 96 |
1/(1+d)^n | Discount factor @ 12% | 1.000 | 0.893 | 0.797 | 0.712 | 0.636 |
FCF*Discount factor | PV of FCF | (230.00) | 61.07 | 62.18 | 38.44 | 60.76 |
Sum of all PVs | NPV | (7.56) | ||||
Using IRR() function and FCFs | IRR | 10.49% |
The project should not be accepted as it has a negative NPV and its IRR is less than the cost of capital of 12%. It is a loss-making project.