Question

Howell petroleum is considering a new project that complements its existing business. The machine required for the project costs $3.97 million. The marketing department predicts that sales related to the project will be $2.67 million per year for the next four years, after which the market will cease to exist. The machine will be depreciated down to zero over its four-year economic life using the straight-line method. Cost of goods sold and operating expenses related to the project are predicted to be 25 percent of sales. The company also needs to add net working capital of $320,000 immediately. The additional net working capital will be recovered in full at the end of the project's life. The corporate tax rate is 35 percent. The required rate of return is 13 percent.

A/ What is the NPV for this project?

B/ Should the company proceed with the project?

Answer 1

NPV = present value of cash flows - initial investment

present value of cash flows = year 1 cash flow/(1+required rate of return)¹ + year 2 cash flow/(1+required rate of return)² .... + year 4 cash flow/(1+required rate of return)⁴

A) the NPV for this project is -$479,383.54.

	Years	0	1	2	3	4
	Initial cost	-$3,970,000	0	0	0	0
	Working capital investment	-$320,000	0	0	0	0
	Sales	$0	$2,670,000	$2,670,000	$2,670,000	$2,670,000
Less:	Cost of goods sold	$0	$667,500	$667,500	$667,500	$667,500
Less:	Operating expenses	$0	$667,500	$667,500	$667,500	$667,500
Less:	Depreciation	$0	$992,500	$992,500	$992,500	$992,500
	Pre-tax cash flow	$0	$342,500	$342,500	$342,500	$342,500
Less:	Taxes @ 35%	$0	$119,875	$119,875	$119,875	$119,875
	After-tax cash flow	$0	$222,625	$222,625	$222,625	$222,625
Add back:	Depreciation	$0	$992,500	$992,500	$992,500	$992,500
Add:	Working capital recovery	$0	$0	$0	$0	$320,000
	Net cash flow	-$4,290,000	$1,215,125	$1,215,125	$1,215,125	$1,535,125
	NPV	-$479,383.54

Formulas and calculation

B) the company should not proceed with the project because NPV is negative. Project will generate losses.