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) NOTE: You can show your Excel table in the box below for partial credit, but you are still expected to write your answers and your calculations in the boxes below parts (a)-(g). 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

Considerrations:

1. The Market Research cost of $5000 is considered as sunck cost as it will not change

whether the project is accepted or not.

2. Assuming that the Asset will be depreciated to zero value at Year 4 end

3. Assuming the rate of return 10% for similar risk projects as discount factor for this project.

value at the end of the project.
Acquisition cost of Asset-Capital spending Yr1	160,000	Ans c
Useful life in Years	4
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=20,000-4000=	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	Ans. d
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 can be approved for investment .