Question

Felicity Manufacturing is considering a capital project which will cost $50,000 at Time 0 and which can be sold after 3 years for $10,000. $12,000 must be invested at Time 0 in inventories and receivables; these funds will be recovered when the operation is closed at the end of Year 3. The project will produce sales revenues of $50,000 per year for 3 years; variable operating costs (excluding depreciation) will be 40 percent of sales. No fixed costs will be incurred. Operating cash inflows will begin one year from today (at t = 1). The project will have depreciation expenses of $40,000, $5,000, and $5,000 in Years 1, 2, and 3, respectively. The company has a 40 percent tax rate, enough taxable income from other assets to enable it to get a tax refund on this project if the project's income is negative. The project has a 15 percent required rate of return. Inflation will be assumed to be zero in the next three years. What is the project's NPV?

	a.	$32,784.25
	b.	$24,989.67
	c.	$12,851.75
	d.	$17,436.84
	e.	$7,673.71

Answer 1

Initial Investment=$50,000

Total depreciation in three years =$40,000+$5,000+$5,000=$50,000.

As project will be fully depreciated in three years , Salvage value after three years,$10,000 will be taxable.

Sales revenue per year=$50,000

Variable operating expenses=$50,000*40/100=$20,000 per year       

For the first year, even when profit is negative ,the tax savings on depreciation($4,000) is taken into account as company has taxable income from other assets.In year three intial investment in stocks and working capital is recouped and that amount($12,000) is added to cash flow.

Depreciation is added back after tax calculation, as it is a non cash expense.

CALCULATION OF NPV OF THE PROJECT
YEAR	Investment	Revenue	Cost	Depreciation	PROFIT	Tax@40%	PAT	PAT+dep	Cash Flow	DF@15%	Disc.Cash flow
0	-62000								-62000	1	-62000
1		50000	20000	40,000	-10,000	-4000	-6,000	34,000	34,000	0.869565	29565.2174
2		50000	20000	5000	25,000	10000	15,000	20,000	20,000	0.756144	15122.8733
3	12000	50000	20000	5000	25,000	10000	15,000	20,000	32,000	0.657516	21040.5194
3	10000				10000	4000	6000	6,000	6000	0.657516	3945.09739
											$      7,673.71

Thus NPV=$7,673.71