Question

The life of the project is 5 years.  A feasibility study has been undertaken at a cost of $2 million. The study concluded that at the end of the project the cost of restoring the environment of the mine would be approximately $ 1.2 million.  The project would require capital equipment of $8 million. The shipping and installation costs for this equipment are around $40,000. This equipment will be depreciated on a straight‐line basis over the life of the project to a book value of zero.  At the end of the project, the equipment will be salvaged for $30000 but half of this amount will be used up for cleaning up costs and strengthening the foundations of the floor directly below the equipment when the equipment is removed.  The project will result in additional revenue of $7 million per year and will incur additional costs (excluding depreciation) of $2.5 million per year.  If this project is not undertaken then the area could have been leased out to another company for an annual rent of $ 750,000.  The corporate tax rate is 30% and the required rate of return for projects of this risk level is 9%. Required: (a) Determine the cash flows associated with this project . (b) Compute the NPV and IRR for this project. ‘(c) Advise if you would recommend the project, with reasons.

Answer 1

			Amount of $2 million for feasibility study is sunk cost
			This cost is not relevant for this analysis
			Initial Cash Flow:
			Capital Equipment	$8,000,000
			Shipping and installation cost	$40,000
			Depreciable Cost of equipment	$8,040,000
			Total Initial outlay	$8,040,000
			Annual Depreciation =840000/5=	$1,608,000
			Annual Cash Flow:
		a	Additional Revenue	$7,000,000
		b	Additional Cost	($2,500,000)
		c	Depreciation expense	($1,608,000)
		d=a+b+c	Profit before tax	$2,892,000
		e=d*30%	Tax expense	($867,600)
		f=d+e	After tax profit	$2,024,400
		g	Add: Depreciation (non cash expense)	$1,608,000
		h	Less: Opportunity cost of loss of rent	-$750,000
		i=f+g+h	Annual Cash Flow:	$2,882,400
			Terminal Cash Flow (Year 5)
			Salvage Value (Before tax)	$15,000	(30000/2)
		j	After tax salvage value =15000*(1-0.3)	$10,500
			Before tax Cost of restoring the environment	($1,200,000)
		k	After Tax cost of restoration(1200000*(1-0.3)	($840,000)
		l=j+k	Terminal Cash Flow (Year 5)	($829,500)
		m	Net Cash Flow in Year 5=2882400-829500=	$2,052,900
			Present Value (PV) of Cash Flow
			(Cash Flow)/((1+i)^N)
			i=discount rate =required return =9%=0.09
			N=Year of Cash Flow
		(a)	N	CF	PV=CF/(1.09^N)
			Year	Cash Flow	Present Value
			0	($8,040,000)	($8,040,000)
			1	$2,882,400	$2,644,404
			2	$2,882,400	$2,426,058
			3	$2,882,400	$2,225,742
			4	$2,882,400	$2,041,965
			5	$2,052,900	$1,334,244
				SUM	$2,632,413
		(b)	Net Present Value (NPV)	$2,632,413
			Internal Rate of Return(IRR)	21.44%	(Using IRR Function of excel over the cash flow
		(c)	The project is recommended
			IRR is higher than 9%
			NPV is positive