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

Answer a.

Initial Investment = $72,000
Useful Life = 3 years

Annual Depreciation = Initial Investment / Useful Life
Annual Depreciation = $72,000 / 3
Annual Depreciation = $24,000

Annual Net Income = [(Selling Price per unit - Variable Cost per unit) * Sales Volume - Fixed Costs - Depreciation] * (1 - tax)
Annual Net Income = [($5.00 - $2.00) * 30,000 - $18,000 - $24,000] * (1 - 0.25)
Annual Net Income = $48,000 * 0.75
Annual Net Income = $36,000

Answer b.

Annual Operating Cash Flow = Annual Net Income + Annual Depreciation
Annual Operating Cash Flow = $36,000 + $24,000
Annual Operating Cash Flow = $60,000

Answer c.

Initial Investment in NWC = $340,000

Net Capital Investment = Initial Investment + Initial Investment in NWC
Net Capital Investment = -$72,000 - $20,000
Net Capital Investment = -$92,000

Answer d.

Required return = 20%

NPV = -$92,000 + $60,000/1.20 + $60,000/1.20^2 + $60,000/1.20^3 + $20,000/1.20^3
NPV = $45,962.96

NPV of the project is $45,962.96

Answer e.

Let IRR be i%

NPV = -$92,000 + $60,000/(1+i) + $60,000/(1+i)^2 + $80,000/(1+i)^3
0 = -$92,000 + $60,000/(1+i) + $60,000/(1+i)^2 + $80,000/(1+i)^3

Using financial calculator, i = 48.54%

IRR of the project is 48.54%

Answer f.

NPV of the project is positive and IRR of the project is higher than the required rate of return. Therefore, you should accept this project.