Question

Animation Nation (AN) copies and distributes Japanese animated videos for the U.S. market. In order to better serve this market, it is considering the immediate purchase of new video reproduction equipment costing $600,000.

AN expects this equipment to last 3 years and plans to use straight-line depreciation during its economic life. At the end of three years it will place the equipment at the street curb, from which it will costlessly disappear.

The new equipment is expected to generate sales of $500,000 in the first year, $350,000 in the second year, and $100,000 in the third year. The shrinkage in sales is expected to result from new entries into the market.

In order to support these sales AN will require $50,000 in net working capital (NWC) in the first year, keeping it at that level until the third year, at which time NWC will be drawn down to zero, the level it was at before the project was undertaken.

The costs of goods sold are expected to be $200,000 in the first year, $210,000 in the second year and $80,000 in the third year. The tax rate applicable to AN’s situation is 34%; of course, if EBIT is negative, it will pay no tax.

1.         Develop a Depreciation Schedule.

Time	0	1	2	3
Depreciation

2.         Estimate NWC and NFA. This can be thought of as a pro forma balance sheet.

Time	0	1	2	3
NWC
NFA

3.         Compute ΔNWC and NCS.

Time	0	1	2	3
ΔNWC
NCS

4.         Estimate OCF. Recall that OCF = EBIT + Depreciation – Taxes. This requires the development of what can be thought of as pro forma income statements for years 0, 1, 2 and 3. Each statement should be of the general form

Animation Nation

Pro Forma Income Statement

Year x

Sales

Cost of Goods Sold

Depreciation

EBIT

Taxes

Net Income

Animation Nation

Pro Forma Income Statement

Year 0

Sales                                       

Cost of Goods Sold                

Depreciation                          

EBIT                                      

Taxes                                     

Net Income                            

Animation Nation

Pro Forma Income Statement

Year 1

Sales                           

Cost of Goods Sold    

Depreciation              

EBIT                          

Taxes                         

Net Income                

Animation Nation

Pro Forma Income Statement

Year 2

Sales                           

Cost of Goods Sold    

Depreciation              

EBIT                          

Taxes                                   

Net Income                

Animation Nation

Pro Forma Income Statement

Year 3

Sales                           

Cost of Goods Sold    

Depreciation  

EBIT                         

Taxes                                    

Net Income              

5.         Compute CF. Recall that CF = OCF - DNWC – NCS, where OCF is operating cash flow, CF is cash flow, DNWC is change in net working capital, and NCS is net capital spending. Given this information, complete the table below.

Time	0	1	2	3
OCF
∆NWC
NCS
CF

6.         Determine the required return. By assumption, it is 15%.

7.         Compute NPV.           

8.         Reflect and decide. Should Animation Nation undertake this project?

9.         Compute IRR and decide should Animation Nation undertake the project based on IRR.

Answer 1

1. Company follows straight line depreciation

Depreciation for each year = Capital Spending at start / life of equipment = 600000/3 =200000

Depreciation Schedule

Time	0	1	2	3
Depreciation	0	200000	200000	200000

2. NWC & NFA schedule

Time	0	1	2	3
NWC		50000	50000	0
NFA	600000	400000	200000	0

NFA = Beginning Fixed Asset - Depreciation for the year

3. ΔNWC and NCS

Time	0	1	2	3
ΔNWC	0	-50000	0	50000
NCS	600000	0	0	0

Change in Working Capital = ΔNWC = Closing Working Capital - Opening Working Capital

(However, an increase in working capital is treated as a cash outflow)

4. OCF = EBIT + Depreciation – Taxes

	0	1	2	3
EBIT	-	100,000.00	(60,000)	(180,000)
Depreciation	-	200,000.00	200,000.00	200,000.00
Less Taxes	-	-	-	-
Operating Cash Flow	-	300,000.00	140,000.00	20,000.00

Pro Forma Income Statement
	Year 1
Sales	0
Less Cost of Goods Sold	0
Less Depreciation	0
EBIT	0
Less Taxes	0
Net Income	0

Pro Forma Income Statement
	Year 1
Sales	500000
Less Cost of Goods Sold	-200000
Less Depreciation	-200000
EBIT	100000
Less Taxes	-34000
Net Income	66000

Pro Forma Income Statement
	Year 2
Sales	350000
Less Cost of Goods Sold	-210000
Less Depreciation	-200000
EBIT	-60000
Less Taxes	0
Net Income	-60000

Pro Forma Income Statement
	Year3
Sales	100000
Less Cost of Goods Sold	-80000
Less Depreciation	-200000
EBIT	-180000
Less Taxes	0
Net Income	-180000

5. Cash Flow = OCF - ∆NWC - NCS

Time	0	1	2	3
OCF	0	300000	140000	20000
∆NWC	0	50000	0	-50000
NCS	600000	0	0	0
CF	-600000	250000	140000	70000

6. Required Return is 15%

7. NPV = -230,722

Time	0	1	2	3
CF	-600000	250000	140000	70000
PV	-600000	217391	105860	46026
NPV =	-230722

PV of Year 0 CF = -600000/ (1+15%)^0 = -600000

PV of Year 1 CF = 250000/ (1+15%)^1 = 217391

PV of Year 2 CF = 140000/(1+15%)^2 = 105860

PV of Year 3 Cf = 70000/ (1+15%)^3 = 46026

8. Since the NPV is negative, Animation nation should not take this project

9. IRR can be calculated using Excel function IRR

IRR = - 14.84%, It is below the required return. Project should not be taken