Question

The Elkton Company is considering a new project that requires an initial investment of $24,000,000 to build a new plant and purchase equipment. The investment will be depreciated using the straight line method over 10 years.   The new plant will be built on some of the company's land which has a current, after-tax market value of $5,000,000.  The company will produce widgets at a cost of $130 each and will sell them for $420 each. Annual fixed costs are $500,000.  Sales (in units) are expected to be 150,000 each year for the next 10 years, at which time the project will be abandoned.  At that time, the plant, equipment, and land is expected to be worth $13,400,000 before tax.  The company will need to purchase $1,000,000 worth of inventory & will recapture that investment at the end of the 10^thyear. No other investments in inventory are anticipated.  The cost of capital is 13% and the company's marginal tax rate is 35%.  Pleased do the following:

a)     Based on the NPV Should the project be accepted?

b)     Draft a short memo (paragraph or two) explaining your analysis and recommendation to your supervisor.

Answer 1

The value of land can be ignored for NPV calculation

Initial investment = capital investment + net working capital

Initial investment = 24,000,000 + 1,000,000

Initial investment = 25,000,000

Annual depreciation = 24,000,000 / 10 = 2,400,000

Operating cash flows from year 1 to year 10 = (Sales - variable costs - fixed costs - depreciation)( 1 - tax) + depreciation

Operating cash flows from year 1 to year 10 = [(150,000 * 420) - ( 150,000 * 130) - 500,000 - 2,400,000)( 1 - 0.35) + 2,400,000

Operating cash flows from year 1 to year 10 = [63,000,000 - 19,500,000 - 500,000 - 2,400,000)(0.65) + 2,400,000

Operating cash flows from year 1 to year 10 = 28,790,000

Year 10 non operating cash flow = 1,000,000

Present value of operating cash flows = Annutiy * [ 1 - 1 / ( 1 + R)ⁿ] / R

Present value of operating cash flows = 28,790,000 * [ 1 - 1 / ( 1 + 0.13)¹⁰] / 0.13

Present value of operating cash flows = 28,790,000 * 5.426243

Present value of operating cash flows = 156,221,549.7

Present value of year 10 non operating cash flow = 1,000,000 / ( 1 + 0.13)¹⁰

Present value of year 10 non operating cash flow = 294,588.3481

NPV = present value of cash inflows - present value of cash outflows

NPV = 294,588.3481 + 156,221,549.7 - 25,000,000

NPV = 131,516,138

b)

Since the project has a positive NPV, we should accept the project. A project with higher NPV will create value to the company.