Question

Howell Petroleum is considering a new project that complements its existing business. The machine required for the project costs $3.84 million. The marketing department predicts that sales related to the project will be $2.54 million per year for the next four years, after which the market will cease to exist. The machine will be depreciated down to zero over its four-year economic life using the straight-line method. Cost of goods sold and operating expenses related to the project are predicted to be 25 percent of sales. Howell also needs to add net working capital of $190,000 immediately. The additional net working capital will be recovered in full at the end of the project’s life. The corporate tax rate is 38 percent. The required rate of return for the project is 15 percent.

  

What is the value of the NPV for this project?

Answer 1

Cost of Machine = $3,840,000
Useful Life = 4 years

Annual Depreciation = Cost of Machine / Useful Life
Annual Depreciation = $3,840,000 / 4
Annual Depreciation = $960,000

Initial NWC Requirement = $190,000

Annual Sales = $2,540,000
Annual Cost = 25% * Annual Sales
Annual Cost = 25% * $2,540,000 = $635,000
Tax Rate = 38%

OCF = (Sales - Cost)*(1-tax) + tax*Depreciation
OCF = ($2,540,000 - $635,000)*(1-0.38) + 0.38*$960,000
OCF = $1,545,900

Cash Flow Year 0 = Cost of Machine + Initial NWC Requirement
Cash Flow Year 0 = -$3,840,000 - $190,000
Cash Flow Year 0 = -$4,030,000

Cash Flow Year 1 = OCF
Cash Flow Year 1 = $1,545,900

Cash Flow Year 2 = OCF
Cash Flow Year 2 = $1,545,900

Cash Flow Year 3 = OCF
Cash Flow Year 3 = $1,545,900

Cash Flow Year 4 = OCF + NWC Recovered
Cash Flow Year 4 = $1,545,900 + $190,000
Cash Flow Year 4 = $1,735,900

NPV = -$4,030,000 + $1,545,900/1.15 + $1,545,900/1.15^2 + $1,545,900/1.15^3 + $1,735,900/1.15^4
NPV = $492,144.17

NPV of this project is $492,144.17