Question

You are considering a 3-year project of which details are summarized below. Your required rate of return for capital budgeting purposes is 20 percent.

• Annual sales = 30,000 units
• Unit sales price = $5.00
• Variable costs = $2.00 per unit
• Annual fixed costs = $18,000
• Initial capital investment = $72,000, depreciated to zero over 3 years
• Initial investment in working capital = $20,000, fully recovered at the end of the project
• The tax rate is 25%

a. What is the project’s annual net income?

b. What is the project’s annual operating cash flow?

c. What is the project’s initial capital investment?

d. What is the project’s NPV?  

e. What is the project’s IRR?  

f. Should you accept this project? Why or why not?

Answer 1

Tax rate		25%
Calculation of annual depreciation
Depreciation		Year-1
Cost		$                72,000
Dep Rate		33%
Depreciation		$                24,000
Calculation of after-tax salvage value
Cost of machine			$             72,000
Depreciation			$             72,000
WDV			$                      -
Sale price			$                      -
Profit/(Loss)			$                      -
Tax			$                      -
Sale price after-tax			$                      -
Calculation of annual operating cash flow
		Year-1
No of units		30,000.00
Selling price		$                          5
Operating ost		$                          2
Sale		$              150,000
Less: Operating Cost-60%		$                60,000
Contribution		$                90,000
Less: fixed cost		$                18,000
Less: Depreciation		$                24,000
Profit before tax		$                48,000
Tax@25%		$                12,000
Annual net income		$                36,000
Add Depreciation		$                24,000
Annual operating cash flow		$                60,000
Calculation of initial outlay
Equipment cost	$               72,000
Working capital	$               20,000
Total initial investment	$               92,000
Calculation of NPV
						20.00%
Year		Capital	Working capital	Operating cash	Annual Cash flow	PV factor	Present values
0		$              (72,000)	$           (20,000)		$              (92,000)	1.0000	$              (92,000)
1				$              60,000	$                60,000	0.8333	$                50,000
2				$              60,000	$                60,000	0.6944	$                41,667
3		$                         -	$             20,000	$              60,000	$                80,000	0.5787	$                46,296
					Net Present Value		$               45,963
Calculation of IRR
			48.00%		49.00%
Year		Total cash flow	PV factor @ 48%	Present values	PV factor @ 49%	Present values
0		$              (92,000)	1.000	$            (92,000)	1.000	$           (92,000)
1		$                60,000	0.676	$              40,541	0.671	$             40,268
2		$                60,000	0.457	$              27,392	0.450	$             27,026
3		$                80,000	0.308	$              24,678	0.302	$             24,184
				$                   611		$                (522)
		IRR	=Lower rate + Difference in rates*(NPV at lower rate)/(Lower rate NPV-Higher rate NPV)
		IRR	'=48%+ (49%-48%)*(610.506/(610.506-(-521.56)
			48.539%

Since IRR is 48.54% is higher than the cost of capital i.e. 20% and hence, the project should be accepted.