Question

Your company is about to undertake a major investment project. The project will require an initial outlay of $100 million for fixed assets plus another $50 million for working capital. Tax authorities will allow you to depreciate the fixed assets on a straight-line basis over four years to a salvage value of zero. In fact, however, you expect that you can sell the fixed assets for $25 million at the end of Year 4. You also expect that you can recover your working capital at its book value at that time. You expect that the project will generate $60 million in revenue and $30 million in cash operating expenses (excluding depreciation) during each of the next four years. The corporate tax rate is 40%.

1. a) What are the cash flows for each year of the project’s life that you would use in conducting an NPV analysis of the project? (Be sure to show the cash flow components, rather than just showing a single number for each year.)

2. b) If the cost of capital is 10%, what is the project’s NPV?

3. c) What is the minimum price at which you could sell the fixed assets at the end of Year 4 in order for the project to be just acceptable?

Answer 1

a]		0	1	2	3	4
	Revenue		$          60.00	$             60.00	$           60.00	$         60.00
	-Cash operating expenses		$          30.00	$             30.00	$           30.00	$         30.00
	-Depreciation [100/4]		$          25.00	$             25.00	$           25.00	$         25.00
	=NOI		$            5.00	$               5.00	$              5.00	$           5.00
	-Tax at 40%		$            2.00	$               2.00	$              2.00	$           2.00
	=NOPAT		$            3.00	$               3.00	$              3.00	$           3.00
	+Depreciation		$          25.00	$             25.00	$           25.00	$         25.00
	=OCF		$          28.00	$             28.00	$           28.00	$         28.00
	-Capital expenditure	$        100.00
	-Change in NWC	$          50.00
	+After tax salvage value [25*(1-40%)]					$         15.00
	+Recapture of NWC					$         50.00
	Annual project cash flows	$      -150.00	$          28.00	$             28.00	$           28.00	$         93.00
b]	PVIF at 10% [PVIF = 1/1.1^10]	1	0.90909	0.82645	0.75131	0.68301
	PV at 10%	$      -150.00	$          25.45	$             23.14	$           21.04	$         63.52
	NPV	$         -16.85
c]	For the project to be just acceptable, the NPV should be 0.
	For that to happen, the price should be more by 16.85*1.1^4/(1-40%) =	$          41.12
	Given price	$          25.00
	Minimum price	$          66.12
	CHECK:
	Annual project cash flows as at [a]	$      -150.00	$          28.00	$             28.00	$           28.00	$         93.00
	After tax value of increase in price = 41.12*(1-40%) =					$         24.67
	Revised project cash flows	$      -150.00	$          28.00	$             28.00	$           28.00	$       117.67
	PVIF at 10% [PVIF = 1/1.1^10]	1	0.90909	0.82645	0.75131	0.68301
	PV at 10%	$      -150.00	$          25.45	$             23.14	$           21.04	$         80.37
	NPV	$             0.00