Question

RET Inc. currently has one product, low-priced stoves. RET Inc. has decided to sell a new line of medium-priced stoves. Sales revenues for the new line of stoves are estimated at $20 million a year. Variable costs are 80% of sales. The project is expected to last 10 years. Also, non-variable costs are $2,000,000 per year. The company has spent $3,000,000 in research and a marketing study that determined the company will lose (cannibalization) $4 million in sales a year of its existing low-priced stoves. The production variable cost of the existing low-priced stoves is $2 million a year.

The plant and equipment required for producing the new line of stoves costs $20,000,000 and will be depreciated down to zero over 20 years using straight-line depreciation. It is expected that the plant and equipment can be sold (salvage value) for $12,000,000 at the end of 10 years. The new stoves will also require today an increase in net working capital of $3,000,000 that will be returned at the end of the project.

The tax rate is 30 percent and the cost of capital is 10%.

1. What is the initial outlay (IO) for this project?

2. What is the annual Earnings before Interests, and Taxes (EBIT) for this project?

3. What is the annual net operating profits after taxes (NOPAT) for this project?

4. What is the annual incremental net cash flow (operating cash flow: OCF) for this project?

5. What is the remaining book value for the plant at equipment at the end of the project?

6. What is the cash flow due to tax on salvage value for this project? Enter a negative # if it is a tax gain. For example, if your answer is a tax on capital gains of $3,004.80 then enter -3,005 ; if your answer is a tax shelter from a capital loss of $1,000,20 then enter 1,000

7. What is the project's cash flow for year 10 for this project?

8. What is the Net Present Value (NPV) for this project?

Answer 1

Solution 1- Calculation of initial outlay

Cost of Machine 20,000,000

Working capital 3,000,000

Total 23,000,000

Initial research expenses are already incurred. Project acceptance or rejection will not bring this money back so these are considered as the sunk cost which will not be considered while making a financial decision about the project.

Solution 2- Calculation of EBIT

Tax rate	30%
	Year-1
Sale	$    20,000,000
Less: Operating Cost	$    16,000,000
Contribution	$      4,000,000
Less: non-variable	$      2,000,000
Less: cannibalization loss (4 million-2million)	$      2,000,000
Less: Annual depreciation Depreciation-20000000/20	$      1,000,000
Profit before tax	$    (1,000,000)

Since introduction of new product will reduce the sale of low cost products and hence contributions made from those

units will be considered as cost for this new product.

Solution 3- Calculation of Operating profit after tax

Profit before tax	$    (1,000,000)
Tax	$        (300,000)
Profit After Tax	$       (700,000)

Solution 4- Calculation of Operating cash flow after tax

Profit After Tax	$       (700,000)
Add Depreciation	$      1,000,000
Cash Profit After-tax	$         300,000

Solution 5- Calculation of remaining WDV of equipment

Cost of machine		$     20,000,000
Depreciation for 10 years -10*1000000		$     10,000,000
WDV		$     10,000,000

Solution 6- Calculation of salvage value

WDV		$     10,000,000
Sale price		$     12,000,000
Profit/(Loss)		$       2,000,000
Tax		$          600,000
The sale price after tax		$     11,400,000

We can also say that cash flow due to tax on salvage value is -600,000 which is reducing the salvage value from 12,000,000 to 11,400,000.

Solution 7: Calculation of project cash flow for year 10
Salvage value	11,400,000
Working capital recovered	3,000,000
Operating cash for year 10	300,000
Total cash flow for year 10	14,700,000

Solution 8: Calculation of NPV

Calculation of NPV
					10.00%
Year	Captial	Working captial	Operating cash	Annual Cash flow	PV factor	Present values
0	$ (20,000,000)	$     (3,000,000)		$(23,000,000)	1.0000	$ (23,000,000.00)
1			$           300,000	$       300,000	0.9091	$         272,727.27
2			$           300,000	$       300,000	0.8264	$         247,933.88
3			$           300,000	$       300,000	0.7513	$         225,394.44
4			$           300,000	$       300,000	0.6830	$         204,904.04
5			$           300,000	$       300,000	0.6209	$         186,276.40
6			$           300,000	$       300,000	0.5645	$         169,342.18
7			$           300,000	$       300,000	0.5132	$         153,947.44
8			$           300,000	$       300,000	0.4665	$         139,952.21
9			$           300,000	$       300,000	0.4241	$         127,229.29
10	$    11,400,000	$       3,000,000	$           300,000	$ 14,700,000	0.3855	$      5,667,486.35
				Net Present Value		$ (15,604,806.50)