Question

Parker & Stone, Inc., is considering a new project that requires an initial fixed asset investment of 1.2 million. The project also requires an initial investment in net working capital of $250,000. The project is expected to generate $950,000 in sales and cost $400,000 every year for three years. The fixed asset follows a straight-line depreciation. After three years, the fixed asset has a zero book value but is estimated to have a market value of $200,000, and the net working capital will fully recovery. The corporate tax rate is 35%.

a. What are the operating cash flows in each year?
b. What are the cash flows from net working capital and the net capital spending in year 3?
c. What are the CFFA in each year?
d. If the required return is 10% for a similar risk level of project, should the company implement this project?

Answer 1

Initial Investment = $1,200,000
Useful Life = 3 years

Annual Depreciation = Initial Investment / Useful Life
Annual Depreciation = $1,200,000 / 3
Annual Depreciation = $400,000

Initial Investment in NWC = $250,000

Salvage Value = $200,000

After-tax Salvage Value = $200,000 * (1 - 0.35)
After-tax Salvage Value = $130,000

Annual Operating Cash Flow = (Sales - Costs) * (1 - tax) + tax * Depreciation
Annual Operating Cash Flow = ($950,000 - $400,000) * (1 - 0.35) + 0.35 * $400,000
Annual Operating Cash Flow = $550,000 * 0.65 + 0.35 * $400,000
Annual Operating Cash Flow = $497,500

Answer a.

Year 1:

Operating Cash Flow = $497,500

Year 2:

Operating Cash Flow = $497,500

Year 3:

Operating Cash Flow = $497,500

Answer b.

Additional Cash Flows = NWC recovered + After-tax Salvage Value
Additional Cash Flows = $250,000 + $130,000
Additional Cash Flows = $380,000

Answer c.

Year 0:

Cash Flow from Assets = Initial Investment + Initial Investment in NWC
Cash Flow from Assets = -$1,200,000 - $250,000
Cash Flow from Assets = -$1,450,000

Year 1:

Cash Flow from Assets = Operating Cash Flow
Cash Flow from Assets = $497,500

Year 2:

Cash Flow from Assets = Operating Cash Flow
Cash Flow from Assets = $497,500

Year 3:

Cash Flow from Assets = Operating Cash Flow + Additional Cash Flows
Cash Flow from Assets = $497,500 + $380,000
Cash Flow from Assets = $877,500

Answer d.

Required return = 10%

NPV = -$1,450,000 + $497,500/1.10 + $497,500/1.10^2 + $877,500/1.10^3
NPV = $72,708.49

NPV of the project is positive, therefore, the company should implement this project.