Question

​Drilling-Easy (DE) Inc. currently has two​ products, low-priced drills and a line of smart drill bits. DE Inc. has decided to sell a new line of​ high-priced drills. Sales for the new line of drills are estimated at ​$17 million a year. Annual variable costs are 60​% of sales. The project is expected to last 5 years. In addition to the production variable​ costs, the fixed costs each year will be ​$2 comma 000 comma 000. The company has spent ​$1 comma 000 comma 000 in a marketing and research study that determined the company will gain ​$10 million in sales a year of its existing line of smart drill bits. The production variable cost of these sales is ​$8 million a year. The plant and equipment required for producing the​ high-priced drills costs ​$11 comma 000 comma 000 and will be depreciated down to zero over 10 years using​ straight-line depreciation. It is expected that the plant and equipment can be sold for ​$5 comma 000 comma 000 at the end of the project. The project will also require an increase in net working capital of ​$4 comma 000 comma 000 today that will be returned at the end of the project. The tax rate is 20 percent and the require rate of return for this project is 7​%.

4 part question

a. What is the initial outlay​ (IO) for this​ project?

b. What is the operating cash flows​ (OCF) for each of the years for this​ project?

c. What is the termination value​ (TV) cash flow​ (aka recovery cost or​ after-tax salvage​ value, or liquidation value of the​ assets) at the end of the​ project?

d. What is the NPV of this​ project?

Answer 1

Time line		0	1	2	3	4	5
Cost of new machine		-11000000
Initial working capital		-4000000
=a. Initial Investment outlay		-15000000
								100.00%
Sales			27000000	27000000	27000000	27000000	27000000
Profits	Sales-variable cost		8800000	8800000	8800000	8800000	8800000
Fixed cost			-2000000	-2000000	-2000000	-2000000	-2000000
-Depreciation	Cost of equipment/no. of years		-1100000	-1100000	-1100000	-1100000	-1100000	5500000	=Salvage Value
=Pretax cash flows			5700000	5700000	5700000	5700000	5700000
-taxes	=(Pretax cash flows)*(1-tax)		4560000	4560000	4560000	4560000	4560000
+Depreciation			1100000	1100000	1100000	1100000	1100000
=b. after tax operating cash flow			5660000	5660000	5660000	5660000	5660000
reversal of working capital							4000000
+Proceeds from sale of equipment after tax	=selling price* ( 1 -tax rate)						4000000
+Tax shield on salvage book value	=Salvage value * tax rate						1100000	=5100000	=c. liquidation value
=Terminal year after tax cash flows							9100000
Total Cash flow for the period		-15000000	5660000	5660000	5660000	5660000	14760000
Discount factor=	(1+discount rate)^corresponding period	1	1.07	1.1449	1.225043	1.310796	1.4025517
Discounted CF=	Cashflow/discount factor	-15000000	5289719.626	4943663.2	4620246	4317986.9	10523676
d. NPV=	Sum of discounted CF=	14695291.72