Question

(20 Marks)

Homantin, Inc. is considering a project for opening a new sporting goods store in a suburban mall. Homantin will lease the needed space in the mall. Equipment and fixtures for the store will cost $600,000. It is the accounting policy of the company to depreciate equipment and fixtures over a 5-year period on a straight-line basis with no residual value. However, the manager expects equipment and fixtures to be sold at $20,000 at the end of 5 years. The new store will require Homantin to increase its net working capital by $200,000 when the project is launched. First-year sales are expected to be $1,000,000 and to increase at an annual rate of 7 percent over the expected 5-year life of the store. Operating expenses (including lease payments and excluding depreciation) are projected to be $800,000 during the first year and increase at a 6 percent annual rate. Homantin’s marginal tax rate is 35 percent and Homantin needs to pay capital gain tax. Assume that the required rate of return for Homantin is 15%.

Required:

(a)	Evaluate the initial outlay of the project.
(b)	Analyze the annual net cash flows for the first 4 years of the project. Please show your calculation steps in a table.
(c)	What is the annual net cash flow at the end of the project?
(d)	Discuss whether you would accept or reject the project if the required payback period is 4 years.
(e)	How about your decision if profitability index and internal rate of return are employed, respectively?
(f)	What would be your decision if the net present value rule is used?

Answer 1

Answer (a):

Initial outlay of the project = Cost of equipment and fixtures + increase in net working capital

= $600,000 +$200,000

= $800,000

Initial outlay of the project = $800,000

Answer (b):

Annual net cash flows for the first 4 years of the project:

Answer (c):

Annual net cash flow at the end of the project ( Year 5):

Answer (d):

As calculated above:

Payback period = 4.05 years

As such you would reject the project if the required payback period is 4 years.

Answer (e):

As calculated above:

Profitability index of the project = 0.97

IRR of the project = 13.94%

Project should be rejected since:

(i) Profitability index < 1

(ii) IRR < Required rate of return

Answer (e):

As calculated above (table in answer d above):

NPV = - $27,626.25

Project should be rejected if the net present value rule is used since NPV is negative.