Question

Two years ago, Omega Enterprises considered starting a project, which requires an initial investment of $1 million for plant and equipment. The depreciation schedule is 60%, 30%, and 10% in years 1, 2, and 3 respectively, although the assets can be used for five years. At the end of the fifth year, the resale value of these assets will be $200,000. This project will generate additional pre-tax annual revenue of $800,000. The associated incremental pre-tax expenses will be $200,000 per year. The risk involved in the cash flows of the project is quantified in terms of the beta, which is 1.5. The required return on the market portfolio is 10% and the risk free rate of return is 5%. Assume Omega pays 40% marginal tax. (The discount rate for the project is computed by adding the risk free rate and the risk premium for the project. The risk premium for the project is the beta of the project’s cash flows and the risk premium for the market portfolio.) (i) Should Omega have accepted this project? (ii) If by accepting the project, the working capital would increase by $300,000, should the project be accepted? .

Answer 1

Answer i
Calculation of NPV of project to decide whether project should be accepted or not
Year	-	1	2	3	4	5	NPV
Initial Investment	-$1,000,000.00
Operating Cash flow		$600,000.00	$480,000.00	$400,000.00	$360,000.00	$360,000.00
Resale value of assets (post tax)						$120,000.00
Net Cash flow	-$1,000,000.00	$600,000.00	$480,000.00	$400,000.00	$360,000.00	$480,000.00
x Discount factor @ 12.50%	1.00000	0.88889	0.79012	0.70233	0.62430	0.55493
Present Values	-$1,000,000.00	$533,333.33	$379,259.26	$280,932.78	$224,746.23	$266,365.90	$684,637.50
NPV of project is positive , hence Omega should accept the project.
Answer ii
Calculation of NPV of project to decide whether project should be accepted or not
Year	-	1	2	3	4	5	NPV
Initial Investment	-$1,000,000.00
Increase in working capital	-$300,000.00
Operating Cash flow		$600,000.00	$480,000.00	$400,000.00	$360,000.00	$360,000.00
Resale value of assets (post tax)						$120,000.00
Net Cash flow	-$1,300,000.00	$600,000.00	$480,000.00	$400,000.00	$360,000.00	$480,000.00
x Discount factor @ 12.50%	1.00000	0.88889	0.79012	0.70233	0.62430	0.55493
Present Values	-$1,300,000.00	$533,333.33	$379,259.26	$280,932.78	$224,746.23	$266,365.90	$384,637.50
NPV of project is positive , hence Omega should accept the project even though there is increase in working capital by $300000
Working
Calculation of Discount rate for the project
Discount rate for the project = Risk free rate of return + [Project beta * Risk premium]
Risk free rate of return = 5%
Project beta = 1.5
Risk premium = Required return on the market portfolio - Risk free rate of return = 10% - 5% = 5%
Discount rate for the project = 5% + [1.5 * 5%] = 0.125 i.e. 12.50%
Calculation of operating cash flow
Year	1	2	3	4	5
Additional pre tax revenue	$800,000.00	$800,000.00	$800,000.00	$800,000.00	$800,000.00
Less : Incremental pre tax expense	$200,000.00	$200,000.00	$200,000.00	$200,000.00	$200,000.00
Less : Depreciation	$600,000.00	$300,000.00	$100,000.00
Profit before tax	$0.00	$300,000.00	$500,000.00	$600,000.00	$600,000.00
Less : Tax @ 40%	$0.00	$120,000.00	$200,000.00	$240,000.00	$240,000.00
Add : Depreciation	$600,000.00	$300,000.00	$100,000.00
Operating cash flow	$600,000.00	$480,000.00	$400,000.00	$360,000.00	$360,000.00
Calculation of depreciation on Plant and machinery
Year	1	2	3
Cost of plant & machinery	$1,000,000.00	$1,000,000.00	$1,000,000.00
Depreciation rate	60%	30%	10%
Depreciation	$600,000.00	$300,000.00	$100,000.00