Question

The manufacturing firm Rebo is considering a new capital investment project. The project will last for five years. The anticipated sales revenue from the project is $3 million in year 1 and $4.2 million in each of years 2 – 5. The cost of materials and labour is 50% of sales revenue and other expenses are $1 million in each year. The project will require working capital investment equal to 20% of the expected sales revenue for each year. This investment must be in place at the start of each year. Working capital will be recovered at the end of the project’s life.

The project will require $2.5 million to be spent now on new machinery which will have zero value at the end of the project and will be depreciated each year at 20% of the original cost. The tax rate is 25%. Rebo uses a discount rate of 11% to evaluate its capital investment projects.

(i) What is the net income in each year?

(ii) What is the free cash flow in each year and the net present value (NPV)?

(iii)You discover the following additional information:

• The project will utilise a building that the firm leases. No other activities take place in it. If this project does not go ahead the firm will terminate the lease in one year’s time if no other use for it has been found.

• Part of each year’s cash flows from the project will be used to increase the dividend payment to shareholders.

  For each of these items, explain briefly whether or not you would incorporate the information into your analysis of the project’s value.

Answer 1

ANSWER:

i)Net income in each year

		( $)	($)	($)	($)	( $)
Sales revenue		3000000	4200000	4200000	4200000	4200000
Cost of materials & labor		1500000	2100000	2100000	2100000	2100000
Other expenses		1000000	1000000	1000000	1000000	1000000
Depreciation ==>[2500000/5]		500000	500000	500000	500000	500000
Net operating income			600000	600000	600000	600000
Tax @ 25%			150000	150000	150000	150000
Net income			450000	450000	450000	450000

ii) free cash flow in each year and the net present value (NPV)

	($)	($)	($)	($)	($)	($)
Net income			450000	450000	450000	450000
Depreciation		500000	500000	500000	500000	500000
Operating Cash Flow		500000	950000	950000	950000	950000
Capital expenditure	2500000
Change in NWC	600000	240000				-840000
Free cash flow	3100000	260000	950000	950000	950000	1790000
present value interest factor @ 11%	1	0.9009	0.8116	0.7311	0.6587	0.5934
present value of Free cash flow at 11% [FCF*PVIF}	3100000	234234	771041	694632	625794	1062278
NPV [Total PresentValue of Free cash flow for years 0-5]	28798

iii)

The lease rent for the first year may be given anyhow. However, it will be acquired simply if, the current project proceeds forward. So, the lease rent.

And should be practiced as an outflow in determining Net Income and Free Cash Flow. The advanced raise in dividend payment as an outcome of the project will have a presence on the cost of equity. That will raise the cost of equity which, has to be thought in the calculation of WACC.