Question

answer question

AAA Corp. currently has one​ product, high-priced lawn mowers. AAA Corp. has decided to sell a new line of​ medium-priced lawn mowers. The building and machinery for producing this new line is estimated to cost ​$12,000,000 and it will be depreciated down to zero over 30 years using​ straight-line depreciation.​ Also, an investment today on working capital in the amount of ​$2,000,000 is needed. The working capital will be recovered at the end of the project. Sales for the new line of lawn mowers are estimated at ​$16 million a year. Annual variable costs are 60% of sales. The project is expected to last 10 years. In addition to the production variable​ costs, the fixed costs each year will be ​$2,000,000. The company has spent ​$1,500,000 in a marketing study that determined the company will lose ​$10 million in sales a year of its existing​ high-priced lawn mowers. The production variable cost of these sales is ​$8 million a year. It is expected that at the end of the​ project, the building and machinery can be sold for 8,000,000. The tax rate is 30 percent and the cost of capital is 8%

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

b. What is the operating cash flows​ (OCF) for each of the years for this​ project?

c. What is the termination value​ (TV) cash flow​ (aka recovery cost or​ after-tax salvage​ value, or liquidation value of the​ assets) at the end of the​ project?

d. What is the NPV of this​ project?

Answer 1

Tax rate		30%
Calculation of annual depreciation
Depreciation		Year-1
Cost		$        12,000,000
Dep Rate= 1/30		3.33%
Depreciation		$              400,000
Calculation of after-tax salvage value
Cost of machine			$     12,000,000
Depreciation for 10 years			$       4,000,000
WDV			$       8,000,000
Sale price			$       8,000,000
Profit/(Loss)			$                      -
Tax			$                      -
Sale price after-tax			$       8,000,000
Calculation of annual operating cash flow
		Year-1
Sale		$        16,000,000
Less: Operating Cost-60%		$          9,600,000
Contribution		$          6,400,000
Less: contribution lost (10-8)		$          2,000,000
Less: fixed cost		$          2,000,000
Less: Depreciation		$              400,000
Profit before tax		$          2,000,000
Tax@30%		$              600,000
Annual net income		$          1,400,000
Add Depreciation		$              400,000
Annual operating cash flow		$          1,800,000
Calculation of initial outlay
Equipment cost	$        12,000,000
Working capital	$          2,000,000
Total initial investment	$       14,000,000
Calculation of terminal value
Equipment salvage value	$          8,000,000
Working capital recovered	$          2,000,000
Total initial investment	$       10,000,000
Calculation of NPV
						8.00%
Year		Capital	Working capital	Operating cash	Annual Cash flow	PV factor	Present values
0		$       (12,000,000)	$      (2,000,000)		$      (14,000,000)	1.0000	$ (14,000,000.00)
1				$        1,800,000	$          1,800,000	0.9259	$    1,666,666.67
2				$        1,800,000	$          1,800,000	0.8573	$    1,543,209.88
3				$        1,800,000	$          1,800,000	0.7938	$    1,428,898.03
4				$        1,800,000	$          1,800,000	0.7350	$    1,323,053.74
5				$        1,800,000	$          1,800,000	0.6806	$    1,225,049.75
6				$        1,800,000	$          1,800,000	0.6302	$    1,134,305.33
7				$        1,800,000	$          1,800,000	0.5835	$    1,050,282.71
8				$        1,800,000	$          1,800,000	0.5403	$        972,483.99
9				$        1,800,000	$          1,800,000	0.5002	$        900,448.14
10		$          8,000,000	$       2,000,000	$        1,800,000	$        11,800,000	0.4632	$    5,465,683.16
					Net Present Value		$    2,710,081.40

Initial marketing cost will be treated as sunk cost as this cost is already incurred and no role will it play in determining whether the project should be taken or not.

Contribution lost from the current sale will be treated as cash cost for the new product line to evaluate if this new project will be able to generate sufficient cash profits to recover the cost of capital and also the lost contribution.