In: Finance
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?
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.