Question

Company AAA is considering a new project. They have paid a market research firm $5,000 to evaluate viability of the potential investment. The company is expected to sell 80,000 units at $3 each, operating expenses equal to 35% of sales, and fixed cost equal to $30,000 every year. The plan for the company is to operate for 4 years. The company also needs to build its inventory, which requires an upfront investment of $8,000. To start its operations, the company bought today new equipment worth of $160,000, which will depreciate straight line over the next 4 years. At the end of the investment horizon you will be able to sell these assets for $20,000. Assume the tax rate is 20%, and that projects with similar risk have a required return (i.e., discount rate) of 10%. (SHOW YOUR WORK. Correct answers with no formulas/calculations receive no credit) a) Find the Operating Cash Flows for each year (show your work/calculations). b) Find the change in net working capital (∆NWC) for each year (show your work/calculations). c) Find Net Capital Spending (NCS) for each year, and the after tax cash flow from the sale of assets in year 4 (show your work/calculations). d) Find the CFFA for each year (show your work/calculations). e) Find the NPV of this project. (show your work/calculations). f) Find the IRR of the project. (show your work/calculations). g) Should you invest in the project and why?

Answer 1

Assuming Market research cost is sunk cost and not relevant.

Assuming the Asset will be depreciated to zero
value at the end of the project.
Acquisition cost of Asset-Capital spending Yr1	160,000	Ans c
Useful life	4 years
Annual SL depreciation	40,000
Annual Depreciation Tax saving @40000*20%=	8,000
Salvage value after 4 years	20,000
Capital Gain on salvage	20,000
Tax rate	20%
Tax on salvage Capital Gain	4,000
After Tax Cash flow from sale of assets Yr 4 end=	16,000	Ans c
Incremental NWC investment in Year 0	8,000	Ans b
Return of NWC in Year 4	8,000	Ans b
Operating Annual Cash flow
Annual Sales Revenue(80,000 units @$3 each)	240,000
Annual Operating expense @35% of sales	84,000
Annual Fixed cost	30,000
EBIT (w/o depreciation)	126,000
Tax @20%	25,200
After Tax Annual Operating Income	100,800
Add: Annual Depreciation Tax savings	8,000
Annual Operating Cash flow	108,800

	NPV Calculation:
	Details	Year 0	Year 1	Year 2	Year 3	Year 4
	Initial Investment
	Investment in Equipment	(160,000)
	investment in NWC	(8,000)
a	Total Initial Investment	(168,000)
b	Annual Operating Cash flow		108,800	108,800	108,800	108,800
	Terminal Cash flow
	After Tax salvage value					16,000
	Return on NWC					8,000
c	Total Terminal Cash flow					24,000
d	Total CFFA from project each Year =a+b+c	(168,000)	108,800	108,800	108,800	132,800
e	PV factor @10%=1/1.1^n=	1	0.9091	0.8264	0.7513	0.6830
f	PV of FCF =d*e=	(168,000)	98,909	89,917	81,743	90,704
g	NPV =Summ of PV of Free Cash flows	$           193,273.68	Ans e
h	IRR (using excel formula)=	54.87%	ans f

Ans g
As the NPV is positive and IRR much above the hurdle rate , the project is worth investing.