Question

Problem: Sam has requested that you (1) identify all of the cash flows for this project, (2) calculate the project's NPV and IRR, and (3) provide your recommendation regarding whether the project should be accepted or rejected. The details of your cash-flow projections should be clearly presented. Show all work.

ABC Company is examining a new capital-investment proposal that would greatly increase the production of diapers. The proposal involves an investment in some machines that would increase the firm's efficiency at producing and preparing for export the top-quality diapers for which the region has become well-known. The purchase price of this machinery is $840,000 and installation costs would total $60,000. The equipment would have a useful life of 5 years and, for tax purposes, depreciation charges would be according to the 7-year-asset MACRS schedule. The machinery cost and the installation costs should be capitalized at t=0 and fully depreciated using the MACRS schedule. Management expects the machinery to be sold for a scrap value of $210,790 at the end of year 5. Ramon Rodriguez, the firm's accountant, pointed out that the portion of the factory that would house this new equipment machinery underwent a major 'renovation' 15 months ago with a total cost of $105,200. Because the project would not have been feasible without the renovation, Ramon suggests that the costs of the renovation should be allocated to the project as one of its initial expenses. Interest charges associated with this investment’s financing have been estimated at approximately $70,000 per year, for each year of the project's estimated useful life. The incremental sales (revenues) projections for this investment are shown near the end of this problem statement. Variable operating costs, excluding depreciation, are projected to be 40% of same-year sales. Incremental fixed costs (for maintenance, etc.) are projected to be $25,000 in the first year. For each of the remaining years of operation, this fixed-cost component is projected to increase by 2% per year. If the new machinery is purchased, some of ABC Company’s Net Working Capital (NWC) accounts will be affected. The schedule near the end of the problem statement shows balances for Accounts Receivable, Inventory, and Accounts Payable across the project’s life. Of course, you’ll need to use this information to build the NWC Tracker, which in turn feeds into the ΔNet Working Capital term in the cash-flow worksheet. The Chief Financial Officer of ABC Company, Sam Sand, requests your assistance in preparing an analysis of the net cash flow projections for the proposed investment. Sam believes that the systematic risk of this project is similar to the average systematic risk of other ABC projects. The firm-level required return (also called “hurdle rate” in business lingo) is 10%/year. Sam also indicates that 30% is the appropriate tax rate for this entire analysis. You also have the following information: Sales projections are these for years 1-5: $300,000, $420,000, $510,000, $600,000, and $480,000. The MACRS depreciation schedule for a 7-year asset is as follows: year 1: 14.29%; year 2: 24.49%; year 3: 17.49%; year 4: 12.49%; year 5: 8.93%; year 6: 8.92%; year 7: 8.93%; and year 8: 4.46%. Next, here is the schedule for the various working-capital accounts that will be affected if the project is undertaken:

time	0	1	2	3	4	5
Accts. Receivable	0	27000	39000	45000	51000	0
Inventory	33000	45000	48000	60000	45000	0
Accounts Payable	21000	25200	24600	30000	16800	0

Answer 1

Renovation of factory was not incurred for this project. Hence it is an irrelevant cost, and should not be included in the initial expense of this project

Interest expenses are a financing cash flow, and therefore not be included in the project cash flows. The effects of interest expense are already included in determining the firm's hurdle rate (WACC)

Working capital required in each year = inventory + accounts receivable - accounts payabel

Operating cash flow (OCF) in each year = net income + depreciation

Total depreciation upto end of year 5 = 128,610 + 220,410 + 157,410 + 112,410 + 80,370 = $699,210

Book value of machinery at end of year 5 = total initial investment - total depreciation = $900,000 - $699,210 = $200,790

Before-tax salvage value = $210,790

Profit on sale = Before-tax salvage value - book value =  $210,790 - $200,790 = $10,000

Tax on profit = $10,000 * 30% = $3,000

After-tax salvage value = Before-tax salvage value - tax = $210,790 - $3,000 = $207,790

Project cash flow in year 0 = initial investment - change in NWC

Project cash flow in years 1 to 4 = OCF - change in NWC

Project cash flow in year 5 = OCF - change in NWC + after-tax salvage value

NPV and IRR are calculated using NPV and IRR functions in Excel

NPV is $34,313

IRR is 11.20%

The project should be accepted as the NPV is positive and IRR is higher than hurdle rate