Question

Your employer is considering a capital project that involves installing a new manufacturing facility(to manufacture a new product) at a cost of $30,800,000. The facility will be built on land that was purchased in 2018 for $1,250,000. If the facility is not built on this land, the land will remain unused. The new manufacturing facility, if built, will be depreciated on a straight-line basis over five years, to a salvage value of $2,000,000. If the facility is built, the production there will cause an immediate increase in Inventory of $1,300,000. It will also cause immediate increases in Accounts Receivable of $5,900,000, Accounts Payable of $850,000, and Long-Term Debt of $15.2million.

If built and produced, the new product is expected to generate annual sales of $20,375,000 by the end of the first year. Sales are expected to increase 8% per year. COGS expense is expected to be of $9,780,000 during the first year. Thereafter, COGS is expected to remain at a constant percentage of Sales. Because operating efficiency is expected to improve each year, SG&A expense is expected to remain at $3,750,000 for each of the five years of the project. At the end of the project’s five-year life, production will cease, and the manufacturing facility will be sold for an estimated $4,500,000. At that time, Inventory, Accounts Receivable and Accounts Payable will return to their pre-project levels.

If the project is implemented, it will likely increase sales of the company’s existing complimentary products. The net impact of those sales is expected to be a $2,225,000 annual increase in pre-tax profits.

Your employer’s tax rate is 21%. The firm has 5 million shares of common stock outstanding. The firm requires a 11% rate of return on capital projects of this risk.

Prepare a discounted cash flow analysis to determine whether your employer should implement this capital project. Your analysis should reveal answers to each of the following questions. Clearly label all cells. Highlight the cells that answer the following questions:

1. What is the initial investment amount (Year 0)?
2. What are the total cash flows each year (Years 1-5)
3. What is the NPV?
4. What is the IRR?

Answer 1

1)

Project cash flow -

Below table shows the project cash flow for Year 0 - Year 5

Year	0	1	2	3	4	5
Revenue		$ 20,375,000.00	$ 22,005,000.00	$ 23,765,400.00	$ 25,666,632.00	$ 27,719,962.56
Less: COGS		$    9,780,000.00	$ 10,562,400.00	$ 11,407,392.00	$ 12,319,983.36	$ 13,305,582.03
Operating profit		$ 10,595,000.00	$ 11,442,600.00	$ 12,358,008.00	$ 13,346,648.64	$ 14,414,380.53
Less: SG&A		$    3,750,000.00	$    3,750,000.00	$    3,750,000.00	$    3,750,000.00	$    3,750,000.00
Less: Depreciation		$    5,760,000.00	$    5,760,000.00	$    5,760,000.00	$    5,760,000.00	$    5,760,000.00
Add: Profit from sale of complimentary product		$    2,250,000.00	$    2,250,000.00	$    2,250,000.00	$    2,250,000.00	$    2,250,000.00
Profit Before Tax		$    3,335,000.00	$    4,182,600.00	$    5,098,008.00	$    6,086,648.64	$    7,154,380.53
Less: Tax @ 21%		$        700,350.00	$        878,346.00	$    1,070,581.68	$    1,278,196.21	$    1,502,419.91
Profit After tax		$    2,634,650.00	$    3,304,254.00	$    4,027,426.32	$    4,808,452.43	$    5,651,960.62
Add: Depreciation		$    5,760,000.00	$    5,760,000.00	$    5,760,000.00	$    5,760,000.00	$    5,760,000.00
Free Cash flow from Operation - A		$    8,394,650.00	$    9,064,254.00	$    9,787,426.32	$ 10,568,452.43	$ 11,411,960.62
Purchase of equipment -B	$ (30,800,000.00)
Working Capital - C	$    (8,050,000.00)					$    8,050,000.00
Sale of Equipment - D						$    3,975,000.00
Free Cash flow from project - A+B+C+D	$ (38,850,000.00)	$    8,394,650.00	$    9,064,254.00	$    9,787,426.32	$ 10,568,452.43	$ 23,436,960.62

Note:

1) Sales are expected to grow at 8%. Year 2 sales will be year1 *1.08

2) COGS for Year 2 to Year 5 will be % of COGS/sales of Year 1. This works to 48%

3) Working capital for Year 0 will incldue the  increases in Accounts Receivable of $5,900,000, Accounts Payable of $850,000. Changes in Long term debt is not considered for this project.

4) Sale of equipment workings -

Book value equipment	$      2,000,000.00
Realisable value	$      4,500,000.00
Profit on sale	$      2,500,000.00
Tax on profit of sale	$          525,000.00
Net realisable value	$      3,975,000.00

5) Depreication will be = (Purchase price - salvage value)/Life of asset

Depreciation = (30,800,000-2,000,000)/5 = $ 5,760,000.

6) Land cost should not be conidered as it is a sunk cost and not relevant for decision making.

Net Present Value (NPV) is calculated by discounting the free cash flow with the discounting factor as shown in the below table

Year	Free Cash Flow -A	Discounting Factor @ 11% - B	PV - A x B
0	$       (38,850,000.00)	1	$ (38,850,000.00)
1	$            8,394,650.00	0.901	$      7,562,747.75
2	$            9,064,254.00	0.812	$      7,356,751.89
3	$            9,787,426.32	0.731	$      7,156,481.77
4	$         10,568,452.43	0.659	$      6,961,766.96
5	$         23,436,960.62	0.593	$    13,908,695.41
		NPV (Sum)	$      4,096,443.77

Discounting factor = 1/(1+i)^n
i = Discounting rate (in this case 11%)
n = Period (in thi case 1 to 5).

IRR can be found out using excel funtion [=IRR(cash flow year 0, Year 1.....year 5)]. Alternatively it can be found out using trail and error method. IRR for this project based on the cash flow is 14%.

Conclusion: The company should proceed with the project as the NPV is positive and the IRR is more than the Cost of capital of the company.