Question

You are looking into a factory to make strained peas. You estimate that the equipment will cost $50,000, which you would depreciate over the 10-year life of the project to a book value of zero. The salvage value of the equipment is zero. You think you can sell 15,000 cans at $2/can. The cost of producing the cans is $0.80 each. Your tax rate will be 40%. You plan to maintain an inventory equal to 25% of revenues and you can salvage 80% of this working capital at the end of the project’s life. You plan to use your garage, which means you will have to pay $2,000/year to park your car elsewhere (the good news is that the $2,000/year is tax-deductible). To estimate the cost of capital for the project you look at the following comparable firms:

r* = 0.17

What is the NPV?

Answer 1

Dear Student,

The concept tested in the question is NPV.

Formula of NPV = Present Value of Cash Inflow (PVCI) - Present Value of cash outflow (PVCO)

Calculation

1) PVCI

- Calculation of After tax cash flows (ATCF)

Particulars	Calculation	Amount	Remarks
Revenue	15000*2	30000
Less: Variable Cost	15000*0.80	(12000)
Less: Parking Cost		(2000)	Tax deductible
Less Depriciation	50000/10	(5000)
	Profit Before Tax	11000
Less :Tax @ 40%	0.40* 11000	(4400)
	Profit After Tax	6600
Add : Depriciation		5000	Non cash expenses
	ATCF	11600	Per year

- Calculation of working capital and its realisation

Average capital requires = 25% * 30000 [25% of revenue as per the question]

                                        = 7500

Relisation at year 10 = 7500 * 80% [80% salvage value as given in question]

                                   = 6000

Present Value of cash inflow = 11600 * PVAF (17%, 10) + 6000* PVIF (17%, 10)

                                               = 54039.80 + 1248.22

                                               = 55287.80

2) PVCO

=> Equipment Cost = 50000

+ Working capital =   7500

              Total     = 57500

3) NPV

= 55287.8 - 57500

= (2212.2)

Since the NPV is negative project should not be accepted.

Hope you understand the solution.

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