Question

Tampa Enterprises is considering the addition of a new product line.  The firm would not need additional factory space, but it would require the purchase of $2.45 million of equipment installed.  The equipment would be depreciated using a 7-year accelerated depreciation schedule.  Additional inventory of 13% of the projected increase in next year’s sales would be necessary prior to each year of operation, but the entire value will be recovered at the end of the project.  The firm expects to sell 340,000 units during the first year of the project, increasing to 355,000 units during the next three years before decreasing to 100,000 during the fifth and final year of the project.  The product is expected to be obsolete at that point.  The expected sales price is $13 per unit with a variable cost of $6 per unit during the first year of operations.  Variable costs will increase by 5% per year, but the sales price remains fixed.  Fixed costs are estimated at $610,000 during the first year, but will increase by 6% per year.  The firm’s tax rate is 21%.  The equipment has an estimated salvage value of $500,000.

What is the estimated net present value of the project assuming a required return of 18%?

Management of the firm is concerned the economy is potentially entering a recession, which would decrease the demand for the product to an estimated 100,000 units for all 5 years and force the firm to drop the price to $9.  

What is the estimated net present value of the project assuming a recession?

Based on your calculations, what recommendations would you make to the management of Tampa Enterprises?

Please provide answers in excel if possible.

Answer 1

Operatingcash flow (OCF) each year = income after tax + depreciation - investment in working capital

loss on sale of equipment at end of year 4 = book value - sale price

book value = original cost - accumulated depreciation

after-tax salvage value = salvage value + tax benefit on loss on sale of equipment (the loss is tax deductible, and hence reduces the tax outgo. This is treated as a cash inflow)

NPV is calculated using NPV function in Excel

NPV is $1,172,490

In case of recession

NPV = -$3,087,639

If there is a recession, the NPV is negative.

Therefore, it is recommended not to take up the project if there is a recession.