Question

Ivy is considering a new project. The project will require $2,000,000 for new fixed assets. There is a total of 75,000combjned increase in inventories and account receivables which is partly financed by 25,000 increase is accounts payables. The project has a 6 yr life span. The fixed assets will be depreciated using 7 year MACRS to zero book value over the life of the project. At the end of the project, the fixed assets can be sold for 10% of their original cost. The net working capital returns to its original level and the end of the project. The project is expected to generate annual sales of 3,000 units and the selling price per unit is $1,300 while the variable cost per unit is expected to be $900. Annual fixed costs are expected to be $45,000. The tax rate is 35% and the required rate of return (cost of capital) is 15%. Calculate the projects initial investment costs, annual incremental operating cash flows, and terminal cash flows. What are the projects npv and irr?

Answer 1

Projects initial investment costs = Cost of assets + investment in working capital
= $2,000,000 + 75,000 + 25,000 = $2,100,000

Annual incremental operating cash flows:

Year	1	2	3	4	5	6
Revenue	3,900,000	3,900,000	3,900,000	3,900,000	3,900,000	3,900,000
Less: Variable cost	2,700,000	2,700,000	2,700,000	2,700,000	2,700,000	2,700,000
Less: Fixed cost	45,000	45,000	45,000	45,000	45,000	45,000
Less: Depreciation	285,800	489,800	349,800	249,800	178,600	178,400
Net income	869,200	665,200	805,200	905,200	976,400	976,600
Less: Tax at 35%	304,220	232,820	281,820	316,820	341,740	341,810
Income after tax	564,980	432,380	523,380	588,380	634,660	634,790
Cash flows after tax = income after tax + depreciation	850,780	922,180	873,180	838,180	813,260	813,190

Terminal cash flows = After Tax Proceeds from Equipment Disposal + Any Change in Working Capital
= (2,000,000*10%)-35% + 75,000+ 25,000
= 130,000+ 100,000 = 230,000
Projects npv and irr:

Year	1	2	3	4	5	6
Revenue	3,900,000	3,900,000	3,900,000	3,900,000	3,900,000	3,900,000
Less: Variable cost	2,700,000	2,700,000	2,700,000	2,700,000	2,700,000	2,700,000
Less: Fixed cost	45,000	45,000	45,000	45,000	45,000	45,000
Less: Depreciation	285,800	489,800	349,800	249,800	178,600	178,400
Net income	869,200	665,200	805,200	905,200	976,400	976,600
Less: Tax at 35%	304,220	232,820	281,820	316,820	341,740	341,810
Income after tax	564,980	432,380	523,380	588,380	634,660	634,790
Cash flows after tax	850,780	922,180	873,180	838,180	813,260	813,190
Terminal cash flow						230,000
Total cash flows	850,780	922,180	873,180	838,180	813,260	1,043,190
Discounting factor	0.869565217	0.756143667	0.657516232	0.571753246	0.497176735	0.432327596
PV of cash flows	739,808.70	697,300.57	574,130.02	479,232.14	404,333.95	450,999.82
NPV	1,245,805.20
IRR	35%