Question

Company AAA is considering a new project. They have paid a market research firm $5,000 to evaluate viability of the potential investment. The company is expected to sell 80,000 units at $3 each, operating expenses equal to 35% of sales, and fixed cost equal to $30,000 every year. The plan for the company is to operate for 4 years. The company also needs to build its inventory, which requires an upfront investment of $8,000. To start its operations, the company bought today new equipment worth of $160,000, which will depreciate straight line over the next 4 years. At the end of the investment horizon you will be able to sell these assets for $20,000. Assume the tax rate is 20%, and that projects with similar risk have a required return (i.e., discount rate) of 10%.

a) Find the Operating Cash Flows for each year (show your work/calculations).

b) Find the change in net working capital (∆NWC) for each year (show your work/calculations).   

c) Find Net Capital Spending (NCS) for each year, and the after tax cash flow from the sale of assets in year 4 (show your work/calculations).

d) Find the CFFA for each year (show your work/calculations).

e) Find the NPV of this project. (show your work/calculations).

f) Find the IRR of the project. (show your work/calculations).

g) Should you invest in the project and why?

Answer 1

Particulars	Y1	Y2	Y3	Y4
Sales (80,000 units @$3 each)	2,40,000	2,40,000	2,40,000	2,40,000
Operating expenses @ 35% of sales	84,000	84,000	84,000	84,000
Contribution = Sales-Operating expenses	1,56,000	1,56,000	1,56,000	1,56,000
Fixed costs per year	30,000	30,000	30,000	30,000
Gross profit = Contribution- Fixed costs	1,26,000	1,26,000	1,26,000	1,26,000
Depreciation	40,000	40,000	40,000	40,000
EBIT = Gross profit - Depreciation	86,000	86,000	86,000	86,000
Tax @ 20%	17,200	17,200	17,200	17,200
Net profit = EBIT - Tax	68,800	68,800	68,800	68,800
Operating cash flows = Net profit + Depreciation	1,08,800	1,08,800	1,08,800	1,08,800

a) Operating cash flow each year = $108,800

b) Change in Net working capital each year: There is no change in Net working capital as the sales are constant and the cash flows each year is also constant. Working capital = Current assets - Current liabilities

Working capital for Y1 to Y4 = $8,000 (Initial investment in inventory)

c) Net capital spending (NCS) = Cost of the project - Depreciation + Salvage value (after tax)

Y1 = 160,000-40,000+16,000 = $136,000

Y2 = 160,000-80,000+16,000 = $ 96,000

Y3 = 160,000-120,000+16,000= $ 56,000

Y4 = $16,000

After tax cash flow from the sale of assets in Y4 = $ 16,000

d) Cash flow from assets = Operating Cash Flows - Capex - Change in Working capital

Y1 to Y4 = 108,800-40,000-8,000 = $ 60,800

e)

Company: AAA
Discount rate	10%
Cash Flows for 4 Years
Year	CF	PVF @10 %	Disc CF
0	$ -1,60,000.00	1.0000	$ -1,60,000.00
1	$ 1,08,800.00	0.9091	$     98,909.09
2	$ 1,08,800.00	0.8264	$     89,917.36
3	$ 1,08,800.00	0.7513	$     81,743.05
4	$ 1,08,800.00	0.6830	$     74,311.86
4	$     20,000.00	0.6830	$     13,660.27
NPV			$ 1,98,541.63

f)  

IRR is the rate at which PV of Cash Inflows are equal to PV of Cash Out flows
Year	Cash Flow	PVF/PVAF @ 58 %	PV of Cash Flows	PVF/PVAF @59 %	PV of Cash Flows
1-4	$           1,08,800.00	1.4475	$               1,57,485.79	1.4297	$             1,55,553.95
4	$              20,000.00	0.1605	$                    3,209.24	0.1565	$                  3,129.26
PV of Cash Inflows			$              1,60,695.02		$             1,58,683.21
PV of Cash Outflows			$              1,60,000.00		$             1,60,000.00
NPV			$                       695.02		$                 -1,316.79

IRR = Rate at which least +ve NPV + [ NPV at that rate / Change in NPV due to Inc of 1% in Int Rate ] * 1%
= 58 % + [695.02 / 2011.81 ] * 1%
= 58 % + [0.3455 ] * 1%
= 58 % + [0.3455 % ]
= 58.3455 %

g) We can invest in the project as it has positive NPV and also the IRR is more than the required return on the investment