Question

Arnold Inc. is considering a proposal to manufacture high-end protein bars used as food supplements by body builders. The project requires use of an existing warehouse, which the firm acquired three years ago for £1 million and which it currently rents out for £120,000 per year. Rental rates are not expected to change in the near future. In addition to using the warehouse, the project requires an up-front investment into machines and other equipment of £1.4m. This investment can be fully depreciated straight-line over the next 10 years for tax purposes. However, Arnold Inc. expects to terminate the project at the end of eight years and to sell the machines and equipment for £500,000. Finally, the project requires an initial investment into net working capital equal to 10% of predicted first-year sales. Subsequently, net working capital is 10% of the predicted sales over the following year. Sales of protein bars are expected to be £4.8 million in the first year and to stay constant for eight years. Total manufacturing costs and operating expenses (excluding depreciation) are 80% of sales, and profits are taxed at 30%.

i. What are the free cash flows of the project? ii. If the cost of capital is 15%, what is the NPV of the project?

Answer 1

Calculation of initial cost
Investment in Plant &machinery				=	£         1,400,000
Investment in working capital				=	£4,800,000*10%
				=	£             480,000
	Total investment			=	$1,400,000+$480,000
				=	£         1,880,000
Calculation of depreciation
	Value of Machine & equipment			=	£         1,400,000
	Life			=	10 years
	Depreciation			=	Value /Life
				=	$1,400,000/10
				=	£             140,000
Calculation of After tax sale value of equipment & machineries
		WDV after 8 years		=	Cost-Depreciation for 8 years
				=	£1,400,000-( £140,0008*)
				=	£1,400,000- £1,120,000
				=	£             280,000
		Tax on sale(capital gain)		=	[Sale Value-WDV]*30%
				=	[ £500,000- £280,00]*30%
				=	£220,000*30%
				=	£               66,000
		After tax sale value		=	sale value-tax on sale
				=	£500,000- £66,000
				=	£             434,000
Calculation of Free cashflow
	Year		1	2	3	4	5	6	7	8	Total
(a)	Sales		£        4,800,000	£ 4,800,000	£         4,800,000	£        4,800,000	£ 4,800,000	£ 4,800,000	£    4,800,000	£   4,800,000
(b)	Cost(a*80%)		£        3,840,000	£ 3,840,000	£         3,840,000	£        3,840,000	£ 3,840,000	£ 3,840,000	£    3,840,000	£   3,840,000
(c.)	Depreciation		£            140,000	£     140,000	£             140,000	£            140,000	£      140,000	£      140,000	£        140,000	£       140,000
(d)	Rent forgone(oppurtunity cost)		£            120,000	£     120,000	£             120,000	£            120,000	£      120,000	£      120,000	£        120,000	£       120,000
(.e)	Profit(a-b-c-d)		£            700,000	£     700,000	£             700,000	£            700,000	£      700,000	£      700,000	£        700,000	£       700,000
(f)	Tax(e*30%)		£            210,000	£     210,000	£             210,000	£            210,000	£      210,000	£      210,000	£        210,000	£       210,000
(g)	Net profit(e-f)		£            490,000	£     490,000	£             490,000	£            490,000	£      490,000	£      490,000	£        490,000	£       490,000
(h)	Cash flow after tax(g+c)		£            630,000	£     630,000	£             630,000	£            630,000	£      630,000	£      630,000	£        630,000	£       630,000
(i)	working capital released									£       480,000
(j)	After Tax sale value									£       434,000
(k)	Free cashflow(h+i+j)		£            630,000	£     630,000	£             630,000	£            630,000	£      630,000	£      630,000	£        630,000	£   1,544,000
(m)	PVF@15%		£              0.8696	£        0.7561	£               0.6575	£              0.5718	£        0.4972	£        0.4323	£          0.3759	£         0.3269
(n)	Present Value(k*m)		£            547,826	£     476,371	£             414,235	£            360,205	£      313,221	£      272,366	£        236,840	£       504,736	£    3,125,801
	Sum of all present value of all cash inflows				=	£ 3,125,800.77
				NPV	=	PV of inlow-outflow
					=	£3,125,800- £1,880,000
					=	£3,125,800- £1,880,000
					=	£1,245,801
	* Working capital is always realized at the end of project unless stated otherwise.There is no change in sales and no additional working capital was required in any year
	*Rent not received is a oppurtunity cost and hence considered as outflow.
	*Alternatively you can ignore Capital gain tax since only tax rate for profit is given.However it is prudent to assume tax on capital gain.