Question

Your company, Fun with Finance, has just completed a $5 million marketing survey that suggests that your new computer role-playing game: "A day in prison with Mr. Madoff" is going to be a big hit. Producing the game will require an immediate $20 million capital investment in new equipment. At the same time, net working capital will have to increase from $3 million to $4 million, and remain at that level for the life of the project. The game is expected to produce revenues of $23 million per year and costs of $10 million per year for 4 years, starting one year from today. Fun with Finance has an existing overhead cost of 6 million. This project will share 5% of the existing overhead cost in income statement. This project requires hiring new managers that will cost $0.5 million per year. Your tax rate is 40%. The new equipment will be depreciated over 4 years to a book value of 0 using the straight-line method. You have contracted to sell the equipment for $2 million at the end of the fourth year, at which point production will end and net working capital will return to the original $3 million level. Assume that the correct discount rate for this project is 11%. Show the relevant cash flows for this project and compute its NPV.

Answer 1

Computation of relevant cashflows:

Sl No	Years	0	1	2	3	4
i	Revenue (Given)		23,000,000	23,000,000	23,000,000	23,000,000
ii	Variable cost (Given)		10,000,000	10,000,000	10,000,000	10,000,000
iii	Manager salary (Given)		500,000	500,000	500,000	500,000
iv	Depreciation (20million/4year)		5,000,000	5,000,000	5,000,000	5,000,000
v	EBIT (i-ii-iii-iv)		7,500,000	7,500,000	7,500,000	7,500,000
vi	Tax @ 40% (v*40%)		3,000,000	3,000,000	3,000,000	3,000,000
vii	NOPAT (v-vi)		4,500,000	4,500,000	4,500,000	4,500,000
viii	Add back: Depreciation (iv)		5,000,000	5,000,000	5,000,000	5,000,000
ix	Operating cashflow (vii+viii)		9,500,000	9,500,000	9,500,000	9,500,000
x	Cost of equipment (Given)	-20,000,000
xi	Sale of equipment after tax (2million*0.6)					1,200,000
xii	Net incremental working capital (Given)	-1,000,000				1,000,000
xiii	Net cashflow (ix+x+xi+xii)	-21,000,000	9,500,000	9,500,000	9,500,000	10,500,000
xiv	PVF @ 11%	1	1/1.11 = 0.9009	0.9009/1.11 = 0.8116	0.8116/1.11 = 0.7312	0.7312/1.11 = 0.6587
xv	Present value of cash flow (xiii*xiv)	-21,000,000	8,558,550	7,710,200	6,946,400	6,916,350

NPV = ΣPresent value of cash flow = -21,000,000+8,558,550+7,710,200+6,946,400+6,916,350 = $9,131,500
Since the NPV is positive accept the project.
Note: Existing overhead cost of $6million is not relevant for this project, hence not taken into account. Whether this project is accepted or not, the overhead will be incurred, hence irrelevant.
Sale of equiment is $2million, tax on sale = $2million*40% = 0.8million, Sale net of tax = $1.2million