Question

A proposed investment has a project life of four years. The necessary equipment will cost of $1,200, and have a useful life of 4 years. The cost will be depreciated straight-line to a zero salvage value, but will have a market worth $500 at the end of the project’s life. Cash sales will be $2,190 per year for four years and cash costs will run $670 per year. Fixed cost is $176 per year. The firm will also need to invest $390 in net working capital. Last year, marketing research for this project cost $1,500. The appropriate discount rate is 5.8%, and the corporate marginal tax rate is 28% while the average tax rate is 34%.

(A.) What are the cash flows from assets (CFFA) for this project?   

(B.) What is the Net Present Value (NPV) of this project?

(C.) What is the Profitability Index (PI) of this project?

(D.) What is the Payback Period for this project?

(E.) What is the Internal Rate of Return (IRR) for this project?

Answer 1

	0	1	2	3	4
Investment	-1200
NWC	-390				390
Salvage					500
Sales		2190	2190	2190	2190
Costs		-846	-846	-846	-846
Depreciation		-300	-300	-300	-300
EBT		1044	1044	1044	1044
Tax (28%)		-292.32	-292.32	-292.32	-292.32
Profits		751.68	751.68	751.68	751.68
CFFA	-1590	1051.68	1051.68	1051.68	1801.68
NPV	$2,669.51
PI	2.68
Payback	1.51
IRR	60.47%

The market research cost is a sunk cost and should not considered in the NPV analysis.

Depreciation = Investment / Life = 1200 / 4 = 300

We use marginal tax rate will calculating profits and cash flows.

Cash Flows = Investment + NWC + Profits + Depreciation + Salvage x (1 - tax rate)

CFFA = 751.68 + 300 = $1,051.68

NPV can be calculated using NPV function in excel or calculator or manually with 5.8% discount rate.

NPV = $2,669.51

PI = 1 + NPV / CF0 = 1 + 2,669.51 / 1,590 = 2.68

Payback Period is the no. of years it takes to recover the investment.

Payback period = 1,590 / 1,051.68 = 1.51 years

IRR can be calculated using the same function in excel or calculator

IRR = 60.47%