Question

Better Mousetraps has developed a new trap. It can go into production for an initial investment in equipment of $6.3 million. The equipment will be depreciated straight line over 6 years to a value of zero, but in fact it can be sold after 6 years for $538,000. The firm believes that working capital at each date must be maintained at a level of 15% of next year’s forecast sales. The firm estimates production costs equal to $1.00 per trap and believes that the traps can be sold for $4 each. Sales forecasts are given in the following table. The project will come to an end in 6 years, when the trap becomes technologically obsolete. The firm’s tax bracket is 35%, and the required rate of return on the project is 9%. Use the MACRS depreciation schedule.

Year:	0	1	2	3	4	5	6	Thereafter
Sales (millions of traps)	0	0.4	0.5	0.7	0.7	0.5	0.4	0

a. What is project NPV? (Negative amount should be indicated by a minus sign. Do not round intermediate calculations. Enter your answer in millions rounded to 4 decimal places.)

b. By how much would NPV increase if the firm depreciated its investment using the 5-year MACRS schedule? (Do not round intermediate calculations. Enter your answer in whole dollars not in millions.)

Answer 1

A.

	Working	Year 0	Year 1	Year 2	Year 3	Year 4	Year 5	Year 6
Initial Investment	A	$           (6.300)
Budgeted Sales (Unit)	B		0.400	0.500	0.700	0.700	0.500	0.400
Budgeted Sales ($)	C=B*4		1.600	2.000	2.800	2.800	2.000	1.600
Variable Cost	D=B*1		(0.400)	(0.500)	(0.700)	(0.700)	(0.500)	(0.400)
Depreciation	E=A/6		(1.050)	(1.050)	(1.050)	(1.050)	(1.050)	(1.050)
Profit Before Tax (EBIT)	C-D-E		0.150	0.450	1.050	1.050	0.450	0.150
Tax@ 35%	EBIT*35%		(0.053)	(0.158)	(0.368)	(0.368)	(0.158)	(0.053)
Profit After Tax	EBIT-Tax		0.098	0.293	0.683	0.683	0.293	0.098
Depreciation add Back	E		1.050	1.050	1.050	1.050	1.050	1.050
Investment in working capital	15%*Incremental Sales	(0.240)	(0.060)	(0.120)	-	0.120	0.060	0.240
Salvage Value (post tax)	538000*(1-.35)							0.3497
Free Cash Flow		(6.540)	1.088	1.223	1.733	1.853	1.403	1.737
Discount Rate	9%	-	0.917	0.842	0.772	0.708	0.650	0.596
Present Value	PV	(6.54)	0.9972	1.0293	1.3375	1.3116	0.9116	1.0354
NPV (in Million)	PV- Y0+Y1+Y2+Y3+Y4+Y5+Y6	$      0.0826

** All figures are in Million

B.

	Working	Year 0	Year 1	Year 2	Year 3	Year 4	Year 5	Year 6
Initial Investment	A	(6,300,000.00)
Budgeted Sales (Unit)	B		400,000.00	500,000.00	700,000.00	700,000.00	500,000.00	400,000.00
Budgeted Sales ($)	C=B*4		1,600,000.00	2,000,000.00	2,800,000.00	2,800,000.00	2,000,000.00	1,600,000.00
Variable Cost	D=B*1		(400,000.00)	(500,000.00)	(700,000.00)	(700,000.00)	(500,000.00)	(400,000.00)
Depreciation (refer table below)	E=A*Depreciation table		(1,260,000.00)	(2,016,000.00)	(1,209,600.00)	(725,760.00)	(725,760.00)	(362,880.00)
Profit Before Tax (EBIT)	C-D-E		(60,000.00)	(516,000.00)	890,400.00	1,374,240.00	774,240.00	837,120.00
Tax@ 35%	EBIT*35%		21,000.00	180,600.00	(311,640.00)	(480,984.00)	(270,984.00)	(292,992.00)
Profit After Tax	EBIT-Tax		(39,000.00)	(335,400.00)	578,760.00	893,256.00	503,256.00	544,128.00
Depreciation add Back	E		1,260,000.00	2,016,000.00	1,209,600.00	725,760.00	725,760.00	362,880.00
Investment in working capital	15%*Incremental Sales	(240,000.00)	(60,000.00)	(120,000.00)	-	120,000.00	60,000.00	240,000.00
Salvage Value (post tax)	538000*(1-.35)							349,700.00
Free Cash Flow		(6,540,000.00)	1,161,000.00	1,560,600.00	1,788,360.00	1,739,016.00	1,289,016.00	1,496,708.00
Discount Rate	9%	-	0.92	0.84	0.77	0.71	0.65	0.60
Present Value	PV	$ (6,540,000.00)	$ 1,064,637.00	$ 1,314,025.20	$ 1,380,613.92	$ 1,231,223.33	$   837,860.40	$   892,037.97
NPV	PV- Y0+Y1+Y2+Y3+Y4+Y5+Y6	$   180,397.8160

Depreciation Table
MACRS Depreciation Rate Table A-1	5 Years
Year1	20%
Year2	32%
Year3	19.20%
Year4	11.52%
Year5	11.52%
Year6	5.76%