Question

Your company is considering a new 3-year project that requires an initial investment in equipment of $3 million. Prior to this, you had engaged a consultant to study the feasibility of the new project and after an extensive market survey, the consultant confirmed your belief that the project would be viable. Your company is charged $100,000 for the feasibility study.
The equipment will be depreciated straight line to zero over the 3 years of its useful life. In addition, you will need to invest $180,000 in net working capital at the initiation of the project. You estimate that the project will produce sales of $3.5 million every year for 3 years, with costs of $1.5 million. The tax rate is 20%.

(a) Calculate the operating cash flow for this project. (10 marks)

(b) (i) Explain how depreciation increases the operating cash flow and what is the
savings for the firm due to depreciation. (5 marks)

(ii) Your colleague tells you that interest expense, if present, should be included in the calculation of operating cash flow because it is a significant expense and it is an actual cash outflow. Is he right? Explain. (5 marks)

(c) The equipment has a market value of $250,000 at the end of the project. What is the net salvage value? Should you include it in the calculation of the project’s NPV? Show why or why not. (5 marks)

(d) The required return on this project is 12%. Taking into account all the above information, determine if you would recommend to invest in this project? (10 marks)

Answer 1

		Years
	Particulars	Y0	Y1	Y2	Y3
a	Initial Investment	30
	Net working Capital	1.8
	SALES		35.00	35.00	35.00
	Cost Against Sales		15.00	15.00	15.00
	Depreciation		0.33	0.33	0.33
	EBIT		19.67	19.67	19.67
	TAX @ 20%		3.93	3.93	3.93
	EAT	31.8	15.73	15.73	15.73
	Add: Depreciation		0.33	0.33	0.33
	Operating Cash Flows		16.07	16.07	16.07
	Total Operating Cash Flows				48.20
	Less: Net Working Capital				1.8
	Net Total Operating Cash flows			46.40
b(i)	The depreciation is not a Actual cash flow, but it is an expenses to the company, By considering depreciation the tax amount will be reduced and as it is not actual cash flow to the company to arrive net operating cash we need to add back after deduction of the Tax.
b(ii)	The Interest expenses are Actual Cash flows to the company, so they are considered for deduction from the cash flows before tax deduction, so it will reduce oour tax burden
C	Value at the End of the Project is 250000, it’s a salvage value of the Asset
	The Book Value of the Asset at the end of third year is "0"
			Amount in $
	Salvage Value		2,50,000
	Less: Book Value		-
	Taxable Salvage Value		2,50,000
	Tax @ 20%		50,000
	Terminal Value		2,00,000
	(generally Short term Capital gain Tax will be applicable for calculation of Tax, as lack information we are considering given Tax rate)
	**The termminal Value will be considered for calculation of NPV, as it is our cash flows
	Notes	Calculation of Depreciation
			Y1	Y2	Y3
	COST OF ASSET	100000
	DEPRECIATION		33,333	33,333	33,333
	** In the Given question he mentioned that value of the Asset at the end of the 3rd year is "0" , So to calculate depreciation under straight line method , we considered salvage value as Zero.