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

Please see below table for calculations:

Particulars	Y1	Y2	Y3	Y4
Sales (80,000 units @$3 each)	2,40,000	2,40,000	2,40,000	2,40,000
Operating expenses @ 35% of sales	84,000	84,000	84,000	84,000
Contribution = Sales-Operating expenses	1,56,000	1,56,000	1,56,000	1,56,000
Fixed costs per year	30,000	30,000	30,000	30,000
Gross profit = Contribution- Fixed costs	1,26,000	1,26,000	1,26,000	1,26,000
Depreciation	40,000	40,000	40,000	40,000
EBIT = Gross profit - Depreciation	86,000	86,000	86,000	86,000
Tax @ 20%	17,200	17,200	17,200	17,200
Net profit = EBIT - Tax	68,800	68,800	68,800	68,800
Operating cash flows = Net profit + Depreciation	1,08,800	1,08,800	1,08,800	1,08,800

a) Operating cash flows each year = $108,800

b) Change in net working capital

Working capital= Current assets- Current liabilities = $8,000 (initial investment in inventory)

Sales through out the period of the project is same and hence there is no change in the net working capital except for the fact that it requires an initial investment of $8,000 in year-1

c) Net Capital Spending (NCS) each year:
Net capital spending = Intial investment in project - Depreciation +Salvage value after tax (at the end of project)

Year-1 = $160,000- $40,000 + 16,000 = $136,000

Year-2 = $160,000-$80,000+16000= $ 96,000

Year-3 = $160,000-$120,000+16000 = $56,000

Year-4= $16000

d) Cash flows from assets:

Y1-Y4= Operating cash flows- CAPEX- Change in Net Working capital

= $ 108,800 - $40,000 - $8,000

= $ 60,800

e) NPV of this project:

Company: AAA
Discount rate	10%
Cash Flows for 4 Years
Year	CF	PVF @10 %	Disc CF
0	$ -1,60,000.00	1.0000	$ -1,60,000.00
1	$ 1,08,800.00	0.9091	$     98,909.09
2	$ 1,08,800.00	0.8264	$     89,917.36
3	$ 1,08,800.00	0.7513	$     81,743.05
4	$ 1,08,800.00	0.6830	$     74,311.86
4	$     20,000.00	0.6830	$     13,660.27
NPV			$ 1,98,541.63

f) IRR

IRR is the rate at which PV of Cash Inflows are equal to PV of Cash Out flows
Year	Cash Flow	PVF/PVAF @ 58 %	PV of Cash Flows	PVF/PVAF @59 %	PV of Cash Flows
1-4	$           1,08,800.00	1.4475	$               1,57,485.79	1.4297	$             1,55,553.95
4	$              20,000.00	0.1605	$                    3,209.24	0.1565	$                  3,129.26
PV of Cash Inflows			$              1,60,695.02		$             1,58,683.21
PV of Cash Outflows			$              1,60,000.00		$             1,60,000.00
NPV			$                       695.02		$                 -1,316.79

IRR = Rate at which least +ve NPV + [ NPV at that rate / Change in NPV due to Inc of 1% in Int Rate ] * 1%
= 58 % + [695.02 / 2011.81 ] * 1%
= 58 % + [0.3455 ] * 1%
= 58 % + [0.3455 % ]
= 58.3455 %

g) The project can be accepted as it has a positive NPV and the IRR is more than the required return on capital