Question

Your firm is considering producing a new variety of widget. You have already test marketed the widgets at a cost of $90,000. You estimate sales will be $500,000 in the first year, $800,000 in the second year, $500,000 in the third year, and zero after three years. To produce the new widgets will require an investment in working capital at year 0 of $50,000. Net working capital will be 20% of sales in years 1 and 2. Labor, materials, and selling expenses will be 60% of sales. An additional $80,000 in promotional expenses will be incurred in the first year of production. You already own sufficient widget-producing equipment to produce the new variety of widget. The equipment was purchased for $1 million, has a book value of $600,000, and is being depreciated at the rate of $200,000 per year. You don't anticipate any use for the surplus capacity of this equipment other than this new variety of widget. To produce the new widgets, you will, however, need additional packaging equipment. The equipment costs $100,000. It will be depreciated straight-line to zero over two years, beginning in the first year of production. The equipment will have no value after three years. Production will also require the use of warehouse space. If this space is not used for the new widgets, it can be rented for $40,000 per year. The tax rate is 40% and the cost of capital is 12%. For this question, only consider sales, expenses, investment, taxes, and the discount rate.

What is the NPV of these cash flows?

Answer 1

additional packaging equipment. The equipment costs $100,000.

estimate sales will be $500,000 in the first year, $800,000 in the second year, $500,000 in the third year, and zero after three years

require an investment in working capital at year 0 of $50,000, Net working capital will be 20% of sales in years 1 and 2.

Labor, materials, and selling expenses will be 60% of sales

An additional $80,000 in promotional expenses will be incurred in the first year of production

. It will be depreciated straight-line to zero over two years

The equipment will have no value after three years.

Production will also require the use of warehouse space. If this space is not used for the new widgets, it can be rented for $40,000 per year.

The tax rate is 40% and the cost of capital is 12%

You have already test marketed the widgets at a cost of $90,000. = This cost is not take in to consider, because it is a sunk cost already incurred, doesn’t change in this decision making

The equipment was purchased for $1 million, has a book value of $600,000, and is being depreciated at the rate of $200,000 per year. == Also this not consider In this decision making. It is already incurred.

Calculate NPV?

Cash flow statement

Years	0	1	2	3
Increase in sales		500000	800000	500000
- Labor, materials, and selling expenses		500000*60% =(300000)	800000*60% =480000	500000*60% =(300000)
= Earning		200000	320000	200000
- additional promotion expenses		(80000)	0	0
= Earnings before tax (not considering dep)		120000	320000	200000
- tax exp @ 40%rate		120000*40% =(48000)	320000*40% =(128000)	200000*40% =(80000)
=Earning after tax		=72000	=192000	=120000
+depreciation tax shield = depreciation exp. * tax rate		50000*40% =20000	50000*40% =20000	0
=Net operating cash flow		=92000	=212000	=120000
Initial investment in equip.	(100000)
Increase in working capital	(50000)	500000*20% =(100000)	800000*20% =(160000)	0
Release working capital at end				50000+100000+ 160000 =310000
Opportunity cost of ware house rent as expense ( net of tax)		40000-40% =(24000)	40000-40% =(24000)	40000-40% =(24000)
=Net Cash flow	(150000)	(32000)	28000	406000
*PV factor $1 @ 12% discount rate	( / 1+12%)0 =1	( / 1+12%)1 =.0.893	( / 1+12%)2 =0.7972	( / 1+12%)3 =0.7118
= PV of Cash flow	(150000)	((28576)	22321.6	288990.8

( straight-line to zero over two years)

depreciation = depreciable base / depreciable life

depreciation = 100000 / 2 = 50000

NPV = PV of cash inflow - PV of cash outflow

PV of cash inflow = 22321.6 + 288990.8 = 311312.4

PV of cash outflow = (150000) + (28576) = 178576

NPV = 311312.4 - 178576 = 132736.4

The project should accept, because the NPV of this project is positive. If it is accept, it will add the values to the business.