Question

White Waters Inc. plans a 4-year capital investment project, where it requires an asset that costs $160,000. The asset will be depreciated using the 3-year MACRS (use these schedule: 33%, 44%, 14%, and 7% for years 1 to 4, respectively). The company expects that the asset will be worth $30,000 at the end of the project. Incremental sales are expected to be $90,000, $120,000, $130,000 and $150,000 for year 1 to 4, respectively. Corresponding variable expenses are expected to be 40% of the sales, and the fixed costs are $25,000 a year. The company will need to invest $14,000 at time=0 in net working capital, which will increase $1,000 each year. The cost of capital is 14% and the corporate tax rate is 30%. White Waters will have to use a building that it bought 15 years ago for $150,000. This building could generate lease income of $20,000 a year if the project is not undertaken. It also spent $80,000 in R&D to develop the new product for this project. To partly finance the project, the company plans to borrow $100,000 at a 10% interest rate for the duration of the project. Develop the cash flows for the project. What are its NPV, IRR, and MIRR? Interpret the results in your own words. For grading details, please see the associated rubric.

Answer 1

In the given question, out of the $ 160000 required for the asset, $ 100000 is being borrowed which means the outflow at Year 0 for the asset is $ 60,000 and R&D expense of $ 80,000 and working capital of $ 14,000

Total outflow at Yr 0 = $ 154,000

outflow at Yr 1 = $ 1000 (additional working capital) = P.V. of $ 1000 = 1000/1.14^1 = $ 877.193

outflow at Yr 2 = $ 1000 (additional working capital) = P.V. of $ 1000 = 1000/1.14^2 = $ 769.468

outflow at Yr 3 = $ 1000 (additional working capital) = P.V. of $ 1000 = 1000/1.14^3 = $ 674.972

outflow at Yr 4 = $ 1000 (additional working capital) = P.V. of $ 1000 = 1000/1.14^4 = $ 592.08

Calculation of yearwise net CASH FLOW

Particulars Year 1 Year 2 Year 3 Year 4 Sales 90000 120000 130000 150000 Less: Variable cost 36000 48000 52000 60000 less: Fixed cost 25000 25000 25000 25000 Less: Depreciation 52800 70400 22400 11200 Less: Loss of lease rental (opportunity cost) 20000 20000 20000 20000 Less: Interest on loan 10000 10000 10000 10000 -53800 -53400 600 23800 Less : Tax @ 30% -16140 -16020 180 7140 Net income -37660 -37380 420 16660 Add: Depreciation 52800 70400 22400 11200 Net cash flow 15140 33020 22820 27860 Present value factor 0.8772 0.7695 0.6750 0.5921 P.V. of cash inflow 13280.70 25407.82 15402.85 16495.36 P.V. OF CASH OUTFLOW AS SEEN ABOVE 877.193 769.468 674.972 592.080 P.V. OF Net cash flow for Year 1 - 4 12403.51 24638.35 14727.88 15903.28
Now we consider salvage and release of working capital and payment of principal amount borrowed So net off tax cash flow at the end of Yr 4 = P.V. of (21000+18000-100000)= $ 36116.90 outflow now we have P.V. of all the cash flows with us, NPV = p.v. of inflow - p.v. of outflow = $ 67673.01 - 36116.9 - 154000 = - 122443.88 since the NPV is negative, the company should not go for the project SINCE THE OUTFLOW ON DOING THIS PROJECT IS MORE THAN WHAT THE COMPANY EARNS OUT OF THIS PROJECT. IRR is the rate at which P.V. of inflows = P.V. of outflows Using the trial and error and interpolation technique (or using IRR function in excel) we get IRR = -18.39% MIRR is modified IRR, it assumes that positive cash flows are reinvested at the firm's cost of capital and not at IRR (this is how it is different from IRR which assumes all positive cash flows are reinvested at IRR itself) Using MIRR function in excel we get MIRR = -16.20%