Question

ABC Co. has recently completed a $200,000, two-year marketing study. Based on the results of the study, Datum has estimated that 5,000 units of its new electro-optical data scanner could be sold annually over the next 5 years, at a price of $5,000 each. Variable costs per unit are $4,000, and fixed costs total $5 million per year. Start-up costs include $15 million to build production facilities, and $4 million in net working capital. The $15 million facility will be depreciated on a straight-line basis to a value of zero over the five-year life of the project. At the end of the project’s life, the production facilities will be sold for an estimated $3 million. Finally, start-up would also entail tax-deductible expenses of $75,000 at year zero. Datum is an ongoing, profitable business and pays taxes at a 35% rate on all income and capital gains. Datum has a 20% cost of capital for projects such as this one. Evaluate the project using NPV. ( Each and every step of calculation required.)

Answer 1

	ABC Co
	The $200,000 Markerting study cost is sunk coas as it is already incurred and will not change wheteher the project is pursued
	or not. So this is not relevant cost for evaluation.
	All Amt in $
	Cash Flow and NPV	Year 0	Year 1	Year 2	Year 3	Year 4	Year 5
	Initial Investment
	Production Facilities	(15,000,000)
	Net working capital	(4,000,000)
	Tax deductible expense	(75,000)
	Add : Tax shield on Tax deductible expense=75000*35%=	26,250
a	Total Investment in Initial Cash Outflow	(19,048,750)
	Cash Flow from Operations
	Sales Revenue for 5000 units @$5000 each		25,000,000	25,000,000	25,000,000	25,000,000	25,000,000
	Less Variable cost @$4000/unit		20,000,000	20,000,000	20,000,000	20,000,000	20,000,000
	depreciation		3,000,000	3,000,000	3,000,000	3,000,000	3,000,000
	Fixed cost		5,000,000	5,000,000	5,000,000	5,000,000	5,000,000
	EBT		(3,000,000)	(3,000,000)	(3,000,000)	(3,000,000)	(3,000,000)
	Tax @35%		(1,050,000)	(1,050,000)	(1,050,000)	(1,050,000)	(1,050,000)
	Income After Tax		(1,950,000)	(1,950,000)	(1,950,000)	(1,950,000)	(1,950,000)
	Add Back depreciation		3,000,000	3,000,000	3,000,000	3,000,000	3,000,000
b	Cash flow from operations		1,050,000	1,050,000	1,050,000	1,050,000	1,050,000
	Terminal cash flows
	Return of Working capital						4,000,000
	After Tax salvage value=$3M*0.65=						1,950,000
c	Total Terminal Cash flow						5,950,000
d	Total Cash flow =a+b+c=	(19,048,750)	1,050,000	1,050,000	1,050,000	1,050,000	7,000,000
e	PV discount factor @20% =1/1.2^n	1	0.8333	0.6944	0.5787	0.4823	0.4019
f	PV of Cash flows=d*e	(19,048,750)	874,965	729,120	607,635	506,415	2,813,300
	NPV =Sum of PV of cash flows=	(13,517,315)
	So NPV of the Start up project is =	$   (13,517,315)