Question

Go Video, a manufacturer of video recorders, is considering a proposal to enter a new line of business. In reviewing the proposal, the company’s CFO is considering the following facts:
The new business will require the company to purchase additional fixed assets that will cost $800,000 at t = 0. For tax and accounting purposes, these costs will be depreciated on a straight-line basis over four years. (Annual depreciation will be $200,000 per year at t = 1, 2, 3 and 4.)
At the end of four years, the company will get out of the business and will sell the fixed assets at a salvage value of $100,000. The project will require a $40,000 increase in net operating working capital at t = 0, which will be recovered at t = 4. The company’s marginal tax rate is 30 percent. The new business is expected to generate $2.5 million in sales each year (at t = 1, 2, and 3). The operating costs excluding depreciation are expected to be $1.5 million per year. The project’s cost of capital is 12 percent.

What is the project’s net present value (NPV)?

Answer 1

Answer : Calculation of Net Present Value :

Below is the table showing Calculation of Net Present Value :

	Year 0	Year 1	Year 2	Year 3	Year 4
Initial Investment	-800000
Annual Sales Revenue		2500000	2500000	2500000	2500000
Cash Operating Cost		-1500000	-1500000	-1500000	-1500000
Less : Depreciation		-200000	-200000	-200000	-200000
Earning before taxes		800000	800000	800000	800000
Taxes @ 30%		-240000	-240000	-240000	-240000
Incremental Net Income		560000	560000	560000	560000
Add : Depreciation		200000	200000	200000	200000
Salvage Value					100000
Tax on Salvage Value (100000*30%)					30000
Less :NWC	-40000
Plus : Recapture of NWC					40000
Operating Cash Flows	-840000	760000	760000	760000	870000
PV Factor @ 12%	1	0.892857	0.797194	0.71178	0.635518
PV of Net Cash flows (Inflow)		678571.4	605867.3	540953	552900.7
PV of Net Cash flows (Outflow)	-840000
(c.)The net present value (NPV) of this project is		= $ 1,538,292.49
NPV = PV of cash inflow - PV of cash outflow
= 2378292.492- 840000
= $ 1538292.49
Book Value = 0 (Since till 4 years machine is fully depreciated
Gain on Sale = Salvage Value - Book Value
= 100000 - 0
= 100000
Tax on Gain on Sale = 100000 * 0.30 = 30000