Question

Belkro Inc. is considering launching a new product that will generate an additional Operating Cash Flow to the firm of $120,000 per year for 5 years.   The project requires an initial capital investment in new equipment of $500,000. The equipment will be depreciated to zero over the life of the project. The project will require an initial increase in inventory of $75,000. Inventory will return to its current level at the end of the project. The company’s tax rate is 34% and its required return for this project is 8%.

Should the company accept the project? Why or why not?

Answer 1

Year 0      
Initial Requirements for Equipment       -500000
      
Working Capital investment       -75000
__________________________________________      
Cash flow year 0       -575000
__________________________________________      
Year 1-5      
Annual operating Cash flow       120000
      
      
Calculation of Year 5 Terminal inflows:      
Net working capital recovered       75000
__________________________________________      
Terminal value       75000
__________________________________________      
      
Calculation of NPV      
Cost of capital (r)       8%
Years (n)=       5

Initial year 0 cash flows Present value is same=       -575000

Present value of Annual operating Cash inflows = Annual amount * (1-(1/(1+r)^n) / r      
120000*(1-(1/(1+8%)^5))/8%      
479125.2044      
      
Present value of year 5 Terminal value = terminal value/(1+i)^n      
75000/(1+8%)^5      
51043.73978      
      
NPV is Sum of present value of all cash flows      
=-500000+479125.2044+51043.73978      
=-$44,831.06      
NPV is   -$44,831.06  
NPV is negative. So Machine should not be purchased      
      
Note : Operating Cash flows include Depreciation tax benefits. So again it will not be calculted