Question

You are evaluating a project for your company. You estimate the sales price to be $630 per unit and sales volume to be 3,300 units in year 1; 4,300 units in year 2; and 2,800 units in year 3. The project has a three-year life. Variable costs amount to $430 per unit and fixed costs are $265,000 per year. The project requires an initial investment of $390,000 in assets which will be depreciated straight-line to zero over the three-year project life. The actual market value of these assets at the end of year 3 is expected to be $63,000. NWC requirements at the beginning of each year will be approximately 30 percent of the projected sales during the coming year. The tax rate is 35 percent and the required return on the project is 9 percent. What change in NWC occurs at the end of year 1?

$189,000

$122,850

$529,200

$343,980

Answer 1

Answer:

Change in NWC occurs at the end of year 1:

Correct answer is: $189,000

Other options are incorrect.

Workings:

NWC requirements at the beginning of each year will be approximately 30 percent of the projected sales during the coming year.

Sales in Year 1 = Sales quantity in Year 1 * Sale Price = 3,300 * $630 = $2,079,000

Sales in Year 2 = 4,300 * $630 = $2,709,000

Year 1 requirement of NWC = 30% * $2,079,000 = $623,700

Year 2 requirement of NWC = 30% * $2,709,000 = $812,700

Increase in NWC requirement in year 2 over year 1 = $812,000 - $623,000 = $189,000

As NWC requirements are at the beginning of year, we can also assume this requirement is at the end of previous year.

This implies for cash flow evaluation, the entire requirement of NWC ($623,700) for year 1, need to be provided for at the end of Year 0.

The incremental requirement of $189,000 of NWC for year 2 have to be provided for at the end year 1.

Hence the change in NWC occurs at the end of year 1 = $189,000