Question

Quad Enterprises is considering a new three-year expansion project that requires an initial fixed asset investment of $2.54 million. The fixed asset will be depreciated straight-line to zero over its three-year tax life and is estimated to have a market value of $272,248 at the end of the project. The project is estimated to generate $2,107,507 in annual sales, with costs of $829,726. The project requires an initial investment in net working capital of $374,305. If the tax rate is 38 percent and the required return on the project is 11 percent, what is the project's NPV?

Answer 1

Solution:
	The project's NPV is          204999
Working Notes:
	For computation of NPV , first of all we get cash flow for each year , then it is discounted using required rate of return as discount rate to get NPV at last
	To get cash flow of each year we should go with flow of transaction going to happen each year
At   Year 0	Year 0 (means at start of project) transactions are of investment in fixed assets & investment in working capital
Hence,	Year 0 cash flow
	=-investment in fixed asset - Investment in net working capital
	(negative as they are cash outflow for the company)
	=-2,540,000 - 374,305
	=      -2,914,305
	Year 1 cash flow
At   Year 1 & 2	In Year 1 & 2 cash flow for the project will be from operating activities which we get from OCF (operating cash flow) formula
	Operating cash flow(OCF) = (Sales - Costs) x (1 − tax rate) + tax rate x ( Annual Depreciation)
	All other items are given, we need to compute annual depreciation for computation tax saving due to depreciation in operating cash flow , and the company policy is to depreciate the fixed asset to zero using straight line method , means we will not consider market value of fixed asset at end of project in computation of depreciation.
	Annual depreciation =cost of fixed asset/life of the fixed asset
	Annual depreciation =2,540,000/3
	Annual depreciation =846,666.66667
For Year 1 & 2	Operating cash flow(OCF) = (Sales - Costs) x (1 − tax rate) + tax rate x ( Annual Depreciation)
	Operating cash flow(OCF) =2,107,507 - 829,726) x (1 - 38%) +   38% x ( 2,540,000/3)
	Operating cash flow(OCF) =792,224.22 + 321,733.33333
	Operating cash flow(OCF) =1,113,957.55333
Hence	Cash flow for year 1 & 2 are
	Year 1 cash flow	1,113,957.55333
	Year 2 cash flow	1,113,957.55333
Year 3 cash flow	In year 3 , transactions are will generate normal operating cash flow as in year 1 & 2 , additional to that net working capital investment in year 0 will be recovered at end of 3rd as positive cash inflow for the project, and at last since the fixed asset is depreciated to zero during its life and sold at end of 3rd year at market value net of taxes.
	Sale value of fixed asset net of taxes = Market value - ( market value - book value) x tax rate
	Sale value of fixed asset net of taxes = 272,248 - ( 272,248 - 0) x 38%
	Sale value of fixed asset net of taxes = 272,248 - 103,454.24
	Sale value of fixed asset net of taxes =168,793.76
Year 3	Year 3 cash flow
	= OCF + recovered net Working capital + Sale value of fixed asset net of taxes
	= 1113957.55333+ 374,305 +168,793.76
	=1,657,056.31333
At Last NPV
Notes:	NPV of project we get by discounting project cash flow with required rate of return , NPV which is positive is acceptable to companies as it shows , the project is able to generate return more than required rate of return.
Year	Cash flow	PVF @11%	Present value
0	-2,914,305	1	-2,914,305.00
1	1,113,957.55333	0.900900901	1,003,565.36
2	1,113,957.55333	0.811622433	904,112.94
3	1,657,056.31333	0.731191381	1,211,625.29
		NPV	204,999
Hence	The project's NPV is          204999
Notes: PVF is calculated @ 11% = 1/(1+0.11)^n     where n is the period for which PVF is calculated.
Please feel free to ask if anything about above solution in comment section of the question.