Question

You are the CFO of Ivanhoe, Inc., a retailer of the exercise machine Slimbody6 and related accessories. Your firm is considering opening up a new store in Los Angeles. The store will have a life of 20 years. It will generate annual sales of 5,500 exercise machines, and the price of each machine is $2,500. The annual sales of accessories will be $600,000, and the operating expenses of running the store, including labor and rent, will amount to 50 percent of the revenues from the exercise machines. The initial investment in the store will equal $34,900,000 and will be fully depreciated on a straight-line basis over the 20-year life of the store. Your firm will need to invest $2,000,000 in additional working capital immediately, and recover it at the end of the investment. Your firm’s marginal tax rate is 30 percent. The opportunity cost of opening up the store is 12.20 percent. What are the incremental free cash flows from this project at the beginning of the project as well as in years 1–19 and 20? (Do not round intermediate calculations. Round NPV answer to 2 decimal places, e.g. 5,265.25 and all other answers to the nearest dollar, e.g. 5,265.)

1. Incremental cash flow at the beginning of the project?

2. Incremental cash flow in the years 1-19

3. Incremental cash flow in the year 20

4. NPV of the project

5. Should the peoject be approved?

Answer 1

1. Incremental cash flow at the beginning of the project is -$36,900,000 ( outflow)

2. Incremental cash flow in the years 1-19 is $ 5,756,000 (inflow)

3. Incremental cash flow in the year 20 is 7,756,000 (inflow)

4. NPV of the project is $ 5,760,808.63

5. Should the project be approved?

   Yes the project is to be accepted because of the positive NPV

Lets compute the total revenue and operating expenses

depreciation will be

Depreciation Exp    =     Initial Investment   - salvage value / useful life of asset                                      

                                 =        34900000      -   0           /    20                                      

                                      =   $ 1,745,000.00         per annum

Based on the above revenue and cost we arrive at profit before tax. tax at 30% on above figure gives tax exp. reducing this tax exp gives the Net profit after tax. we need to add back depreciation exp to this Net profit to arrive at the operating cash flows.( since depreciation is a non cash item) for years 1 to 20

in the first year there is an initial investment to the extent of $34,900,000 and working capital investment to the extent of $ 2000,0000. Both of these will be an outflow in Year 0.

working capital investment to the extent of $ 2000,0000 will be recouped back at the 20th year. So this $2000,000 will be an additional cash in flow apart in 20 th year

Accordingly cash flows are :

excel formulas

       

Based on the above cash flows- we need to compute the NPV.

against each cash flows the discount factor at 12.20% p.a is computed using the formula,

DF = 1 / (1+0.12.2)ⁿ    ; n- number of year.

the cash flows are multiplied with the DF to arrive at the discounted Cfs. sum of these discounted Cash flows will be the NPV of the project.

Alternatively, NPV function can be used.             

excel formulas