Question

Central Food Inc., is considering replacing its current production line to improve efficiency. The new production line will cost $650,000 plus $50,000 for shipping and installation. The current production line has a book value of $74,000 and an estimated market value of $95,000. CF uses straight-line depreciation method and has a marginal tax rate of 25% for net income and capital gain. CF’s current annual sales is $433,000 and by estimation, the new production line can increase CF’s annual sales by about 28%. NWC will rise by $35,000. And due to higher maintenance cost, the operating costs will rise by $15,000 each year. In 11 years the production line currently under consideration can be sold for $110,000. CF’s require rate of return is 11%.

For this replacement project: 1) Find initial investment and all the future incremental cash flows. 2）what is the terminal year cash flow

Answer 1

1]	INITIAL INVESTMENT:
	Cost of new production line including shipping and installation = 650000+50000 =		$       7,00,000
	Gain on sale of old production line = 95000-74000 =	$           21,000
	Tax on gain at 25% = 21000*25% =	$ 5,250
	-After tax sale proceeds from old production line = 95000-5250 =		$           89,750
	Net cost of production line		$ 6,10,250
	+Rise in NWC		$           35,000
	Initial investment		$       6,45,250
2]	INCREMENTAL CASH FLOWS--YEARS 1 TO 10:
	Incremental sales = 433000*28% =	$        1,21,240
	-Incremental operating costs	$           15,000
	-Incremental depreciation = 700000/11-74000/11 =	$           56,909
	=Incremental NOI	$           49,331
	-Tax at 25%	$           12,333
	=Incremental NOPAT	$           36,998
	+Incremental depreciation	$           56,909
	=Incremental OCF	$           93,907
3]	TERMINAL YEAR CASH FLOW:
	Incremental OCF [as at (2) above]	$           93,907
	+After tax salvage value = 110000*(1-25%) =	$           82,500
	+Recpature of NWC	$           35,000
	Terminal year cash flow	$        2,11,407
4]	NPV:
	PV of FCF of years 1 to 10 = 93907*(1.11^10-1)/(0.11*1.11^10) =	$        5,53,040
	+PV of terminal year cash flow = 211407/1.11^11 =	$           67,076
	=PV of cash inflows	$        6,20,116
	-Initial investment	$        6,45,250
	NPV	$          -25,134