Question

1. ABC corporation has existing property and equipment that is not in use. The company is considering the use of this property and equipment. One option is to use the property and equipment to produce a new product. Estimates for demand of this product are 30,000 units annually for the first 5 years and 20,000 units annually for the following 6 years. Beyond that, the product is considered to be obsolete and production will cease. Price and variable costs would be $100 and $65, respectively. Fixed costs would be $225,000 per year. If they take this option, they must buy additional equipment for a total of $2 million. This equipment will be depreciated straight-line over a 15 year period of time. When the project is ended (in 11 years), it is expected they will be able to sell the equipment for $130,000. This option also requires an initial net working capital investment of $400,000. This initial NWC investment can be reduced to $300,000 when sales drop (i.e. from year 5 to year 6). The net working capital will be fully recouped at the end of the project. This project is riskier than the average project for the company. Management has determined that the appropriate discount rate to use will be 12%.
   1. What is this project’s OCF for years 1-5?
   2. What is this project’s OCF for years 6-11?
   3. What is this project’s FCF for year 0?
   4. What is this project’s FCF for years 1-5?
   5. What is this project’s FCF for year 6?
   6. What is this project’s FCF for years 7-10?
   7. What is this project’s FCF for year 11?
   8. What is the project’s NPV?
   9. What is the project’s break-even price?
   10. Does this company have the internal resources to finance this project?
       • Yes
       • No

Answer 1

WORKING FOR COMPUTATION OF (PART a) to (PART g)

Year	Demand	Contribution p.u	Total contribution	Fixed cost	Operating cash flows	WC/ Sales	Free cash flows	PVF@12%	Present value of cash inflow
a	b	c=(100-65)	d=b*c	e	f=d-e	g	h=f-g	i	j=h*i
1	$30,000.00	$35.00	$1,050,000.00	-$225,000.00	$825,000.00	-$400,000.00	$425,000.00	0.8929	$379,464.29
2	$30,000.00	$35.00	$1,050,000.00	-$225,000.00	$825,000.00	-$400,000.00	$425,000.00	0.7972	$338,807.40
3	$30,000.00	$35.00	$1,050,000.00	-$225,000.00	$825,000.00	-$400,000.00	$425,000.00	0.7118	$302,506.61
4	$30,000.00	$35.00	$1,050,000.00	-$225,000.00	$825,000.00	-$400,000.00	$425,000.00	0.6355	$270,095.18
5	$30,000.00	$35.00	$1,050,000.00	-$225,000.00	$825,000.00	-$400,000.00	$425,000.00	0.5674	$241,156.41
6	$20,000.00	$35.00	$700,000.00	-$225,000.00	$475,000.00	-$300,000.00	$175,000.00	0.5066	$88,660.45
7	$20,000.00	$35.00	$700,000.00	-$225,000.00	$475,000.00	-$400,000.00	$75,000.00	0.4523	$33,926.19
8	$20,000.00	$35.00	$700,000.00	-$225,000.00	$475,000.00	-$400,000.00	$75,000.00	0.4039	$30,291.24
9	$20,000.00	$35.00	$700,000.00	-$225,000.00	$475,000.00	-$400,000.00	$75,000.00	0.3606	$27,045.75
10	$20,000.00	$35.00	$700,000.00	-$225,000.00	$475,000.00	-$400,000.00	$75,000.00	0.3220	$24,147.99
11	$20,000.00	$35.00	$700,000.00	-$225,000.00	$475,000.00	$3,530,000.00	$4,005,000.00	0.2875	$1,151,341.80
						TOTAL	$6,605,000.00	-	$2,887,443.31

Part a- Project’s OCF for years 1-5 = $825,000

Part b- Project’s OCF for years 6-11 = $475,000

Part c- Project’s FCF for year 0 = - $ 2,000,000 (i.e purchase price of equipment)

Part d- Project’s FCF for years 1-5 = $425,000

Part e- Project’s FCF for year 6    = $ 175,000

Part f- Project’s FCF for years 7-10 = $75,000

Part g- Project’s FCF for year 11 = $ 4,005,000

Part h- Project’s NPV = PV of cash inflow - PV of cash outflow

=$2,887,443.3 - $2,000,000

=$ 887,443.3

Part i- Break-even price is that level of price where PV of cash inflow is equal to Pv of cash outflow. In above case Breakeven price =$94.2672 (This is that price at which our net benefit from the project will be zero

Part j- Yes the company has internal resources to finance the project (i.e property and equipmrnt that are not in use)

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