Question
In: Finance
A production project will generate an expected operating cash flow of $50,000 per year for 4...
A production project will generate an expected operating cash flow of $50,000 per year for 4 years (years 1 – 4). Undertaking the project will require an increase in the company’s net working capital (inventory) of $10,000 today (year 0). At the end of the project (year 4), inventory will return to the original level. The project would cost $150,000. The marginal tax rate is 35%. The weighted average cost of capital for the firm is 9%. Sketch a timeline to illustrate the relevant cash flows (again, type the table and/or explain in words). What is the net present value of this project?
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Expert Solution
Calculation of NPV
NPV = Present value of cash inflows - Present value of cash outflows
| Particulars | 0 | 1 | 2 | 3 | 4 |
| Cash outflows | |||||
| Cost of Project | $(150,000.00) | ||||
| Increase in working capital | $(10,000.00) | ||||
| Total cash outflows | $(160,000.00) | ||||
| Cash inflows | |||||
| Operating cash flows | $50,000.00 | $50,000.00 | $50,000.00 | $50,000.00 | |
| Less: Depreciation (note 1) | $(37,500.00) | $(37,500.00) | $(37,500.00) | $(37,500.00) | |
| Earnings before tax | $12,500.00 | $12,500.00 | $12,500.00 | $12,500.00 | |
| Less: tax @35% | $(4,375.00) | $(4,375.00) | $(4,375.00) | $(4,375.00) | |
| Earning after tax | $8,125.00 | $8,125.00 | $8,125.00 | $8,125.00 | |
| Add: Depreciation (note 1) | $37,500.00 | $37,500.00 | $37,500.00 | $37,500.00 | |
| Add: Release of Working Capital (note 2) | $10,000.00 | ||||
| Total Cash Inflows | $45,625.00 | $45,625.00 | $45,625.00 | $55,625.00 | |
| Total cash flows ....A | $(160,000.00) | $45,625.00 | $45,625.00 | $45,625.00 | $55,625.00 |
| PVF @ 9% ....B | 1 | 0.917431193 | 0.841679993 | 0.77218348 | 0.708425211 |
| Present value ......AxB | $(160,000.00) | $41,857.80 | $38,401.65 | $35,230.87 | $39,406.15 |
NPV = $(160,000.00+ $41,857.80+ $38,401.65+ $39,406.15
NPV = $(5,103.53)
Decision : Since NPV is negative reject the project.
Note :
1. Since the question does not mention the depreciation rate it has been assumed that the cost of project will be depreciated on SLM basis ver the life of the project
Depreciation = Cost of Project / Life
= $150,000/4 = $37500
Also, since depreciation is a non cash expense it will be added back to earnings after tax.
2. Release of working capital at the end of the project is considered as cash inflow.
***PVF= (1/1+r)^n
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