Question

You have been hired as a consultant for Brilliant Paint Company, Inc. (BPC), manufacturers of fine industrial paint. The market for industrial paint is growing rapidly. The company bought some land three years ago for $1.35 million in anticipation of using it as a toxic paint waste dump site but has recently hired another company to handle all toxic materials. Based on a recent appraisal, the company believes it could sell the land for $1.45 million on an after-tax basis, however, if it waits for 6 years, the land could be sold for $1.55 million after taxes. The company also hired a marketing firm to analyze the paint market, at a cost of $120,000. An excerpt of the marketing report is as follows:

The paint industry will have a rapid expansion in the next five years. With the brand name recognition that BPC brings to bear, we feel that the company will be able to sell 3,000 units in the first year of operation and will increase by 25% in the second. The unite growth will decrease to 20% in the third year and will continue to decrease linearly to 5% every year until the end of the project.

Capitalizing on the name recognition of BPC, we feel that a premium price of $600 can be charged in the first year but due to competition the company needs to keep the price for at least three years. However, the company could increase the price to $625 in year three and maintain it until the end of project life.   

BPC believes that fixed costs for the project will be $500,000 per year, and variable costs are 20 percent of sales. The equipment necessary for production will cost $3 million and will be depreciated according to a six-year MACRS schedule. At the end of the project, the equipment can be scrapped for $375,000. Net working capital of $150,000 will be required immediately but needs to increase it by %5 per year as the sales increases. BPC has a 35 percent tax rate, and the required return on the project is 13 percent.

What is the NPV of the project?

Answer 1

Tax rate	35%
Required Rate of Return	13%
Land	1350
	Sales Growth Rates			25%	20%	15%	10%	5%
	Year	0	1	2	3	4	5	6
	Sales Units		3000	3750	4500	5175	5693	5978
	Unit Price		600	600	625	625	625	625
	Sales in $		1800000	2250000	2812500	3234375	3558125	3736250
	Costs:-
	Fixed Costs		500000	500000	500000	500000	500000	500000
	Variable Costs		360000	450000	562500	646875	711625	747250
	Equipment Book Value	3000000	2562500	2125000	1687500	1250000	812500	375000
	Depriciation for the Year		437500	437500	437500	437500	437500	437500
	Value of Land	1450000						1550000
	Marketing Cost	120000
	Net Working Capital		150000	157500	165375	173643.75	182325.94	191442.23
	Profit Before Tax		502500	862500	1312500	1650000	1909000	2051500
	Profit After Tax		326625	560625	853125	1072500	1240850	1333475
	Free Cash Flow		614125	990625	1282750	1501731.25	1669667.81	1761858.70
	Wind up Sales Proceeds							1925000
	Present Value		543473.45	775804.68	889010.10	921039.90	906228.80	1770866.54
	Sum of Present Values	5806423.47
	Initial Cost Incurred	4570000
	NPV	1236423.47

Formulae used in above table:

Sales in $ = (Sales Units)*(Unit Price)

Variable Costs = (Sales in $)*20%

Depreciation for the Year = ((Equipment Book Value at Year 0)-(Equipment Book Value at Year 6))/6

Equipment Book Value at Year 1 = (Equipment Book Value at Year 0) - (Depreciation for the year) ; (similarly for Year 2 and so on)

Net Working Capital at Year 1 = (Net Working Capital of Year 0)*(1.05) ; (similarly for Year 2 and so on)

Profits Before Tax = (Sales in $) - (Fixed Costs) - (Variable Costs) - (Depreciation for the year)

Profit After Tax = (Profits Before Tax)*(1-35%)

Free Cash Flow for Year 1= (Profit After Tax) + (Depreciation for the year) - ( (Net Working Capital for Year 1) - (Net Working Capital for Year 0) ) ; (similarly for Year 2 and so on)

Wind up Sales Proceeds = (Equipment Book Value at Year 6) + (Land Value at Year 6)

Present Value for Year 'n'= (Free Cash Flow) / ((1+13%)^(n)) ; where n = 1 to 5

Present Value for Year 6 = (Free Cash Flow + Wind up Sales Proceeds) / ((1+13%)^(6))

Initial Cost Incurred = (Equipment Book Value at Year 0) + (Vale of Land at Year 0) + (Marketing Cost)

NPV = (Sum of Present Values) - (Initial Cost Incurred)