Question

The firm has a new product (PLY 55) which has performed well in test marketing trials conducted recently by the research and development (R&D) department. The R&D costs were estimated to be about $200,000. The business development team has prepared the financial projects as follows:


Year 1 2 3 4 5
Sales 220,000 310,000 450,000 410,000 340,000 Cost of sales -77,000 -108,500 -157,500 -143,500 -119,000 Gross profit (50%) 143,000 201,500 292,500 266,500 221,000
Operating expenses -60,000 -61,800 -63,000 -65,300 -67,500 Depreciation -100,000 -100,000 -100,000 -100,000 -100,000 EBIT -17,000 39,700 129,500 101,200 53,500 Tax @ 17% 2,890 -6,749 -22,015 -17,204 -9,095 Net income -14,110 32,951 107,485 83,996 44,405
Net working capital required 33,000 46,500 67,500 61,500 51,000

The initial investment in plant and equipment for this project is $500,000. The plant and equipment is fully depreciated over its useful life using the straight line method. Due to the nature of the product life cycle, this product will be rendered obsolete at the end of five years. At which time, the working capital will be fully recovered and plant and equipment can be sold for about $100,000.

Your boss is unsure if the firm should proceed with this investment. Therefore, she needs you to evaluate this proposal. Assume a discount rate of 9% and tax rate of 17%.

If this project proves to be financially viable, she needs to know whether equity or debt is suitable for financing this investment.

(a) Calculate the free cash flows to firm for Years 0 to 5 for the proposed investment in the new product (PLY 55).

(b) Calculate the net present value (NPV). Recommend whether this potential investment is financially viable.

Answer 1

a]	Net income [as given]		$          -14,110	$         32,951	$      1,07,485	$          83,966	$          44,405
	Add: Depreciation		$        1,00,000	$     1,00,000	$      1,00,000	$      1,00,000	$      1,00,000
	Operating cash flow		$           85,890	$     1,32,951	$      2,07,485	$      1,83,966	$      1,44,405
	-Capital expenditure	$        5,00,000
	-Change in NWC:
	Ending NWC		$           33,000	$         46,500	$          67,500	$          61,500	$                   -
	Beginning NWC		$                     -	$         33,000	$          46,500	$          67,500	$          61,500
	Change in NWC		$           33,000	$         13,500	$          21,000	$          -6,000	$        -61,500
	Terminal value = 100000*(1-17%) =						$          83,000
	FCFF	$      -5,00,000	$           52,890	$     1,19,451	$      1,86,485	$      1,89,966	$      2,88,905
b]	PVIF at 9%	1	0.91743	0.84168	0.77218	0.70843	0.64993
			[1/1.09]	{1/1.09^2]	…...........................................................
	PV at 9% [FCFF*PVIF]	$      -5,00,000	$           48,523	$     1,00,540	$      1,44,001	$      1,34,577	$      1,87,768
	NPV	$        1,15,408
	The investment is financially viable as the NPV is positive.