Question

CAPITAL BUDGETING PROBLEM

Cashman Corp. is considering venturing into the very mysterious Project Z. Information on Project Z follows below.  Cashman’s marginal tax rate is 34%.  Calculate Project Z’s NPV and IRR.  Should Cashman accept Project Z?

? Project Z is a 4?year project; the required return on project Z is 12%.

? Initial (up?front) investment is $1,200,000

? Annual revenues estimated at $4,000,000

? Annual expenses (not including depreciation) estimated at $2,900,000

? Depreciation for tax purposes is based on 6?year life, straight?line, to zero book value at end of 6 years

? At the end of the project (in year 4), will sell Project Z for expected market value of $500,000

? Net Working Capital: initial investment required is $1,100,000 (up?front); after that, NWC levels decrease by $275,000 per year.

Answer 1

Depreciation = 6 year and salvage value = $0

So, Depreciation every year = Initial Investment/no of years = $1200000/6 = $200000

Particulate	Year0	Year 1	Year 2	Year 3	Year 4
Revenue		4000000	4000000	4000000	4000000
Expens (minus)		2900000	2900000	2900000	2900000
Depreciation (minus)		200000	200000	200000	200000
PBT		900000	900000	900000	900000
Tax (34%)		306000	306000	306000	306000
PAT		594000	594000	594000	594000
Depreciation		200000	200000	200000	200000
Cash infow		794000	794000	794000	794000
Initial investment	-1200000

Selling value of project					500000
Net Working capital	-1100000	275000	275000	275000	275000
Net Cash flow	-2300000	1069000	1069000	1069000	1069000
Required return rate(12%)
Present value factor	1	0.89	0.80	0.71	0.64
Present value	-2300000	951410	855200	758990	684160
NPV	949760
IRR	16%

NPV = Cash flow in year 0th year+ 1st year +2nd year+ 3rd Year+4th Year

As NPV = $949760 which is positive. So, Cashman accept Project Z.

IRR is calculated when NPV = 0

IRR

NPV = 0 = -Cash Outflow + Cash inflow

0= -CF0 + CF1/(1+r) + CF2/(1+r)^2 + CF3/(1+r)^3 +CF4/(1+r)^4

0 = -$2300000 + 1069000/(1+r) + 1069000/(1+r)^2 + 1069000/(1+r)^3 + 1069000/(1+r)^4

r =16%