Question

• As a financial analyst, you must evaluate a proposed project to produce printer cartridges. The equipment would cost $55,000, plus $10,000 for installation. Annual sales would be 4,000 units at a price of $50 per cartridge, and the project's life would be 3 years. Current assets would increase by $5,000 and payables by $3,000. At the end of 3 years, the equipment could be sold for $10,000. Depreciation would be based on the MACRS 3-year class; so the applicable rates would be 33%, 45%, 15%, and 7%. Variable costs would be 70% of sales revenues, fixed costs excluding depreciation would be $30,000 per year, the marginal tax rate is 40%, and the corporate WACC is 11%.
• 1. What is the terminal year project cash flow?
• You did a scenario analysis to better understand the project’s NPV:

	Probability	Unit Sales	VC%	NPV
Best case	25%	4,800	60%	39,434
Base case	50%	4,000	70%	4,245
Worst case	25%	3,200	75%	-25,080

The firm's project CVs generally range from 1.0 to 1.5. A 3% risk premium is added to the WACC if the initial CV exceeds 1.5, and the WACC is reduced by 0.5% if the CV is 0.75 or less. Then a revised NPV is calculated. What WACC should be used for this project?

Answer 1

		Terminal Year(Year3) Project Cash Flow
		Depreciation
	A	Asset Cost=55000+10000=	$65,000
	B	Year3 MACRS depreciation rate	15%
	C=A*B	Depreciation	$9,750
		Operating Cash Flow:
	D	Unit sales	4000
	E	Sales Price	$50
	F=D*E	Sales Revenue	$200,000
	G=F*70%	Variable Cost	$140,000
	H	Fixed Cost(excluding depreciation)	$30,000
	I	Depreciation expense	$9,750
	J=F-G-H-I	Operating Profit before tax	$20,250
	K=J*40%	Tax expense	$8,100
	L=J-K	After tax operating Profit	$12,150
	I	Add: Depreciation (non cash expense)	$9,750
	M=L+I	Operating Cash Flow:	$21,900
		Terminal Cash Flow:
		Book Value at end of 3 years=7%*65000	$4,550
		Salvage Value	$10,000
		Gain on Salvage =10000-4550=	$5,450
		Tax on Gain =40%*5450=	$2,180
	N	After tax salvage value=10000-2180=	$7,820
		Release of working Capital:
		Increase in Current asssets	$5,000
		Increase in Accounts Payable	$3,000
	P	Release of working Capital in year3	$2,000
	T=N+P	Terminal Cash Flow	$9,820
	M+T	Terminal Year(Year3) Project Cash Flow	$31,720	(21900+9820)
			p	A	B=p*A	D=A-5711	E=D^2	F=E*p
			Probability	NPV	Probabilty*NPV	Deviation from expected	Deviation Squared	Deviation Squared*Probability
		Best Case	0.25	$39,434	$9,858.50	$33,723.00	$1,137,240,729	$284,310,182
		Base Case	0.5	$4,245	$2,122.50	($1,466.00)	$2,149,156	$1,074,578
		Worst Case	0.25	($25,080)	($6,270.00)	($30,791.00)	$948,085,681	$237,021,420
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