Question

Lee, Inc. is considering the production of a new line of soft drinks at its Springfield, IL plant. The CFO of Lee, Inc. is provided with the following information on the new project:

• The expansion will require the immediate purchase of new machinery for $30,000,000.

• The firm has spent $1,000,000 to train workers to use the new machinery.

• The incremental sales from this project are expected to be $19,500,000 per year. The incremental

  operating expenses (excluding depreciation) are expected to equal $11,300,000 per year.

• The company uses straight-line depreciation. The project has an economic life of 10 years. The machinery has a salvage value of $1,000,000 and will be sold for that amount at the conclusion of the

  project.

• The company will increase net working capital by $1,200,000 at the beginning of the project, and it will

  be liquidated at the end of the project.

• Lee Inc.’s marginal tax rate is 40%.

• Lee Inc.’s weighted average cost of capital (WACC) is 10%.

35. Based on this information, the initial net cash flow of the project (i.e., CF0) is $ _______.

36. Based on this information, the project’s operating net cash flow in year 5 is $_______.

37. The IRR of this project is _____%.

Answer 1

Time line		0	1	2	3	4	5	6	7	8	9	10
Cost of new machine		-30000000
Initial working capital		-1200000
=Initial Investment outlay		a. -31200000
Sales			19500000	19500000	19500000	19500000	19500000	19500000	19500000	19500000	19500000	19500000
Profits	Sales-variable cost		30800000	30800000	30800000	30800000	30800000	30800000	30800000	30800000	30800000	30800000
-Depreciation	Cost of equipment/no. of years		-3000000	-3000000	-3000000	-3000000	-3000000	-3000000	-3000000	-3000000	-3000000	-3000000
=Pretax cash flows			27800000	27800000	27800000	27800000	27800000	27800000	27800000	27800000	27800000	27800000
-taxes	=(Pretax cash flows)*(1-tax)		16680000	16680000	16680000	16680000	16680000	16680000	16680000	16680000	16680000	16680000
+Depreciation			3000000	3000000	3000000	3000000	3000000	3000000	3000000	3000000	3000000	3000000
=after tax operating cash flow			19680000	19680000	19680000	19680000	b. 19680000	19680000	19680000	19680000	19680000	19680000
reversal of working capital												1200000
+Proceeds from sale of equipment after tax	=selling price* ( 1 -tax rate)											600000
+Tax shield on salvage book value	=Salvage value * tax rate											0
=Terminal year after tax cash flows												1800000
Total Cash flow for the period		-31200000	19680000	19680000	19680000	19680000	19680000	19680000	19680000	19680000	19680000	21480000
Discount factor=	(1+discount rate)^corresponding period	1	1.626170955	2.644432	4.3002985	6.9930205	11.371847	18.492567	30.0720752	48.902335	79.52356	129.3189
Discounted CF=	Cashflow/discount factor	-31200000	12102048.64	7442051.9	4576426.5	2814234.6	1730589.6	1064211.4	654427.7329	402434.77	247473.8	166101
NPV=	Sum of discounted CF=	9.57865E-07
c. IRR is discount rate at which NPV = 0 =	62.62%