Question

Layla's Distribution Co. is considering a project which will require the purchase of $1.6 million in new equipment. The equipment will be depreciated straight-line to a zero book value over the 5-year life of the project. Layla's expects to sell the equipment at the end of the project for $180,000. Annual sales from this project are estimated at $1.3 million, and you will incur $100,000 in fixed costs and variable costs equal to 10% of sales. Net working capital equal to 30 percent of sales will be required to support the project and built up in the beginning. All of the net working capital will be recouped at the end of the project. The firm desires a minimal 12 percent rate of return on this project. The tax rate is 30 percent.

1. What is the value of the depreciation tax shield in year 3 of the project? (Answer is 96000?)

2. What is the amount of the net (after-tax) salvage value of the equipment? (Answer is 126,000?)

3. What is the recovery amount attributable to net working capital at the end of the project?

4. What is the operating cash flow each year?

5. What is the IRR of this project?

Answer 1

1: depreciation tax shield= tax rate* Depreciation

= 30%*(1600000/5)

= 96000

2: since book value will be zero at the time of sale, the entire selling price of equipment will be taxable

After-tax salvage value= selling price of equipment* (1-tax rate)

= 180000*(1-0.3)

= 126000

3: recovery amount of net working capital= initial working capital

=30%*1300000

= 390000

4: operating cash flow = (sales-fixed cost-variable cost)*(1-tax rate) + depreciation tax shield

= (1300000-100000-130000)*(1-0.3) + 96000

=845000

5: IRR = 35.02%

WORKINGS