Question

1. Better Mousetraps has developed a new trap. It can go into production for an initial investment in equipment of $6 million. The equipment falls in the 5-year MACRS, it can be sold after 6 years for $500,000. The applicable depreciation rates are 20%, 32%, 19.20%, 11.52%, 11.52% and 5.76%. The firm believes that working capital at each date must be maintained at a level of 10% of next year’s forecast sales. The firm estimates production costs equal to $1.50 per trap and believes that the traps can be sold for $4 each. Sales forecasts are given in the following table. The project will come to an end in 5 years when the trap becomes technologically obsolete. The firm’s tax bracket is 35%, and the required rate of return on the project is 12%.

Year 0: 0

Year 1: 0.5

Year 2: 0.6

Year 3: 1.0

Year 4: 1.0

Year 5: 0.6

Year 6: 0.2

Thereafter 0

1. What is project NPV?

Answer 1

Operating cash flow (OCF) each year = income after tax + depreciation - change in working capital

profit on sale of equipment at end of year 6 = sale price - book value

book value = zero, since the equipment is fully depreciated.

after-tax salvage value = salvage value - tax on profit on sale of equipment   

NPV is calculated using NPV function in Excel

NPV is -$5,639.35