Question

8. After spending $10,000 on client development, you have just been offered a big production contract by a new client. The contract will add $200,000 to your revenues for each of the next 5 years and it will cost you $100,000 per year to make the additional product. You will have to liquidate existing equipment and buy new equipment as well. The existing equipment is fully depreciated but could be sold for $50,000 now. You will buy new equipment valued at $30,000 and use the 5-year MACRS schedule to depreciate it. It will be worthless at the end of the project. Your current production manager earns $80,000 per year. Since she is busy with ongoing projects, you are planning to hire an assistant at $40,000 per year to help with the expansion. You will have to increase your inventory immediately from $20,000 to $30,000. It will return to $20,000 at the end of the project. Your company’s tax rate is 35% and your discount rate is 15%. What is the NPV of the contract? (Answer: $135,452.5) (Hints: The $10,000 on client development has already happened in the past and thus should NOT affect our replacement decision. Our replacement decision depends only on future expected incremental free cash flows resulting from the decision. The costs resulting from past decisions are called sunk costs and are irrelevant to current replacement decision. The salary of current production manager ($80,000) is also considered a sunk cost and is irrelevant information. Assume that we liquidate existing equipment and purchase new equipment in year 0 but put new equipment into work in year 1.)

Year	0	1	2	3	4	5	6
New equipment cost
MACRS depreciation schedule		20%	32%	19.20%	11.52%	11.52%	5.76%
Depreciation expenses

Year	W/O project	0	1	2	3	4	5
Level of NWC
Change in NWC
Subtract change in NWC

Year	0	1	2	3	4	5	6
Revenues
Costs
Gross Profit
Selling, general, and administrative (e.g., salary of a new assistant)
Depreciation
EBIT
Tax (35%)
Incremental Earnings
Add back depreciation
Capital expenditure
Subtract change in NWC
Salvage cash flow
Incremental FCF

Answer 1

Tax rate	35%
	Year-1	Year-2	Year-3	Year-4	Year-5
Revenue	200,000	200,000	200,000	200,000	200,000
Less: Operating Cost	100,000	100,000	100,000	100,000	100,000
Contribution	100,000	100,000	100,000	100,000	100,000
Less: Fixed Cost	40,000	40,000	40,000	40,000	40,000
Less: Depreciation as per table given below	6,000	9,600	5,760	3,456	3,456
Profit before tax	54,000	50,400	54,240	56,544	56,544
Tax	18,900	17,640	18,984	19,790	19,790
Profit After Tax	35,100	32,760	35,256	36,754	36,754
Add Depreciation	6,000	9,600	5,760	3,456	3,456
Cash Profit After tax	41,100	42,360	41,016	40,210	40,210
		New Machine	Old Machine
Cost of macine		30,000
Depreciation for 5 years		28,272
WDV		1,728	-
Sale price		-	50,000
Profit		(1,728)	50,000
Tax		(604.80)	17,500.00
Sale price after tax		605	32,500
Net investment	=32500-30000	2,500
Depreciation	Year-1	Year-2	Year-3	Year-4	Year-5	Total
Cost	30,000	30,000	30,000	30,000	30,000
Dep Rate	20.00%	32.00%	19.20%	11.52%	11.52%
Deprecaition	6,000	9,600	5,760	3,456	3,456	28,272
Calculation of Annual Cash flow
Year	Captial	Working captial	Operating cash	Annual Cash flow	PV factor @ 15%	Present values
0	2,500	(10,000)		(7,500)	1.000	(7,500)
1			41,100	41,100	0.870	35,739
2			42,360	42,360	0.756	32,030
3			41,016	41,016	0.658	26,969
4			40,210	40,210	0.572	22,990
5	605	10,000	40,210	50,814	0.497	25,264
					NPV	135,492