Question
In: Finance
Revenues generated by a new fad product are forecast as follows year Revenues 1 $50,000 2...
Revenues generated by a new fad product are forecast as follows
year Revenues
1 $50,000
2 40,000
3 20,000
4 10,000
Expenses are expected to be 50% of revenues, and working capital required in each year is expected to be 20% of revenues in the following year. The product requires an immediate investment of $40,000 in plant and equipment.
Required:
a. What is the initial investment in the product? Remember working capital.
b. If the plant and equipment are depreciated over 4 years to a salvage value of zero using straight-line depreciation, and the firm’s tax rate is 30%, what are the project cash flows in each year? Assume the plant and equipment are worthless at the end of 4 years.
c. If the opportunity cost of capital is 12%, what is the project's NPV?
d. What is project IRR?
Solutions
Expert Solution
Statement hsowing cash flow due to changes in WC
| Particulars | 0 | 1 | 2 | 3 | 4 |
| Revenue | 50000 | 40000 | 20000 | 10000 | |
| WC (20% of revenues in the following year) | 10000 | 8000 | 4000 | 2000 | 0 |
| Change in WC | 10000 | -2000 | -4000 | -2000 | -2000 |
| Change in cash | -10000 | 2000 | 4000 | 2000 | 2000 |
Statement showing NPV
| Particulars | 0 | 1 | 2 | 3 | 4 | NPV = Sum of PV |
| Investment in plant and equipment. | -40000 | |||||
| Revenue | 50000 | 40000 | 20000 | 10000 | ||
| Expenses(50% of revenue) | -25000 | -20000 | -10000 | -5000 | ||
| Depreciation (40000/4) | -10000 | -10000 | -10000 | -10000 | ||
| PBT | 15000 | 10000 | 0 | -5000 | ||
| Tax @ 30% | -4500 | -3000 | 0 | 1500 | ||
| PAT | 10500 | 7000 | 0 | -3500 | ||
| Add: Depreciation | 10000 | 10000 | 10000 | 10000 | ||
| Annual cash flow | 20500 | 17000 | 10000 | 6500 | ||
| Cash flow due to WC | -10000 | 2000 | 4000 | 2000 | 2000 | |
| Total cash flow | -50000 | 22500 | 21000 | 12000 | 8500 | |
| PVIF @ 12% | 1.0000 | 0.8929 | 0.7972 | 0.7118 | 0.6355 | |
| PV | -50000.00 | 20089.29 | 16741.07 | 8541.36 | 5401.90 | 773.62 |
Thus NPV = $ 773.62
IRR is rate at which NPV is 0
Assume r = 13%, then NPV =
| Particulars | 0 | 1 | 2 | 3 | 4 | NPV = Sum of PV |
| Total cash flow | -50000 | 22500 | 21000 | 12000 | 8500 | |
| PVIF @ 13% | 1.0000 | 0.8850 | 0.7831 | 0.6931 | 0.6133 | |
| PV | -50000.00 | 19911.50 | 16446.08 | 8316.60 | 5213.21 | -112.60 |
Using Interpolation we can find IRR
| R | NPV |
| 12% | 773.62 |
| 13% | -112.6 |
| 1% | 886.22 |
| ? | 773.62 |
= 773.62/886.22
= 0.87
Thus IRR = 12%+ 0.87% = 12.87%
Ans)
a) Initial investment in the product = $50,000
b) Cash flow from project
| Particulars | 0 | 1 | 2 | 3 | 4 |
| Total cash flow | -50000 | 22500 | 21000 | 12000 | 8500 |
c) NPV = $773.62
d) IRR = 12.87%
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