Question

Problem 1 (In order to get credit, show your work and you can copy the tables below into the answer box to fill in.)

Sugar Land Company is considering adding a new line to its product mix, and the capital budgeting analysis is being conducted by a MBA student. The production line would be set up in unused space in Sugar Land’ main plant. Total cost of the machine is $260,000. The machinery has an economic life of 4 years, and MACRS will be used for depreciation. The machine will have a salvage value of 40,000 after 4 years.


The new line will generate Sales of 1,350 units per year for 4 years and the variable cost per unit is $100 in the first year. Each unit can be sold for $200 in the first year. The sales price and variable cost are expected to increase by 3% per year due to inflation. Further, to handle the new line, the firm’s net working capital would have to increase by $30,000 at time zero (The NWC will be recouped in year 4). The firm’s tax rate is 40% and its weighted average cost of capital is 10%.

1. What are the annual depreciation expenses for years 1 through 4? (10 Points)

	Year 1	Year 2	Year 3	Year 4
Depreciation

  

2. Calculate the annual sales revenues and costs (other than depreciation), years 1 through 4. (10 points)

	Year 1	Year 2	Year 3	Year 4
$ Sales
$ Variable costs

  

3. Estimate annual (Year 1 through 4) operating cash flows (40 points)

  

	Year 1	Year 2	Year 3	Year 4
Sales
OCF

  

4. Estimate the after tax salvage cash flow (10 points)
5. Estimate the cash flow of this project (10 Points)

  

	Year 0	Year 1	Year 2	Year 3	Year 4
CF of the project

  

6. Estimate the NPV, IRR, MIRR, and profitability Index of the project. (20 points)

  

NPV =
IRR =
MIRR =
PI

Answer 1

2   3   4
Cost of new machine   -260000              
Initial working capital   -30000              
=Initial Investment outlay   -290000              
3 years MACR rate       33.33%   44.45%   14.81%   7.41%
Sales           275000   278100   286443   295036.2
-variable cost           135000   139050   143221.5   147518.1
Profits           135000   139050   143221.5   147518.1
0   0   0   0
-Depreciation   =Cost of machine*MACR%   -86658   -115570   -38506   -19266
=Pretax cash flows       48342   23480   104715.5   128252.1
-taxes   =(Pretax cash flows)*(1-tax)   29005.2   14088   62829.3   76951.29
+Depreciation       86658   115570   38506   19266
=after tax operating cash flow   115663.2   129658   101335.3   96217.29
reversal of working capital               30000
+Proceeds from sale of equipment after tax   =selling price* ( 1 -tax rate)               24000
+Tax shield on salvage book value   =Salvage value * tax rate               0
=Terminal year after tax cash flows               54000
Total Cash flow for the period   -290000   115663.2   129658   101335.3   150217.3
Discount factor=   (1+discount rate)^corresponding period   1   1.1   1.21   1.331   1.4641
Discounted CF=   Cashflow/discount factor   -290000   105148.4   107155.4   76134.71   102600.4
NPV=   Sum of discounted CF=   101038.9              
PI= (NPV+initial inv.)/initial inv.
=(101038.88+290000)/290000
1.35
IRR is the rate at which NPV =0   0              
IRR   24.80%              
Year   0   1   2   3   4
Cash flow stream   -290000.000   115663.200   129658.000   101335.300   150217.300
Discounting factor   1.000   1.248   1.557   1.944   2.426
Discounted cash flows project   -290000.000   92681.078   83251.307   52137.280   61930.336
NPV = Sum of discounted cash flows                  
NPV Project =   0.000              
Where                  
Discounting factor =   (1 + discount rate)^(Corresponding period in years)  
Discounted Cashflow=   Cash flow stream/discounting factor      
Discounting Approach       Discount rate   10.000%              
All negative cash flows are discounted back to the present at the required return and added to the initial cost       Year   0   1   2   3   4
Thus year 0 modified cash flow=-290000       Cash flow stream   -290000.000   115663.200   129658.000   101335.300   150217.300
=-290000       Discounting factor (Using discount rate)   1.000   1.100   1.210   1.331   1.464
Discounted cash flows   -290000.000   105148.364   107155.372   76134.711   102600.437
Modified cash flow   -290000.000   115663.200   129658.000   101335.300   150217.300
Discounting factor (using MIRR)   1.000   1.248   1.557   1.944   2.426
Discounted cash flows   -290000.000   92681.078   83251.307   52137.280   61930.336
NPV = Sum of discounted cash flows                  
NPV =   0.00              
MIRR is the rate at which NPV = 0                  
MIRR=   24.80%              
Where                  
Discounting factor =   (1 + discount rate)^(Corresponding period in years)  
Discounted Cashflow=   Cash flow stream/discounting factor      
Reinvestment Approach       Discount rate   10.000%              
All cash flows except the first are compounded to the last time period and IRR is calculated       Year   0   1   2   3   4
Thus year 4 modified cash flow=(153947.72)+(156886.18)+(111468.83)+(150217.3)       Cash flow stream   -290000.000   115663.200   129658.000   101335.300   150217.300
=572520.03       Compound factor (Using discount rate)   1.000   1.331   1.210   1.100   1.000
Compounded cash flows   -290000.000   153947.72   156886.18   111468.83   150217.3
Modified cash flow   -290000.000   0   0   0   572520.030
Discounting factor (using MIRR)   1.000   1.185   1.405   1.665   1.974
Discounted cash flows   -290000.000   0.000   0.000   0.000   290000.000
NPV = Sum of discounted cash flows                  
NPV =   0.00              
MIRR is the rate at which NPV = 0                  
MIRR=   18.54%              
Where                  
Compounding factor =   (1 + discount rate)^(time of last CF-Corresponding period in years)
Discounted Cashflow=   Cash flow stream*discounting factor      
Combination approach       Discount rate   10.000%              
All negative cash flows are discounted back to the present and all positive cash flows are compounded out       Year   0   1   2   3   4
to the end of the project’s life       Cash flow stream   -290000.000   115663.200   129658.000   101335.300   150217.300
Compound factor (Using discount rate)   1.000   1.100   1.210   1.331   1.464
Compound factor (Using discount rate)   1.000   1.331   1.210   1.100   1.000
Thus year 4 modified cash flow=(153947.72)+(156886.18)+(111468.83)+(150217.3)       Discounted cash flows   -290000.000   0   0   0   0
=572520.03       Compounded cash flows   0.000   153947.72   156886.18   111468.83   150217.3
Thus year 0 modified cash flow=-290000       Modified cash flow   -290000.000   0   0   0   572520.030
=-290000       Discounting factor (using MIRR)   1.000   1.185   1.405   1.665   1.974
Discounted cash flows   -290000.000   0.000   0.000   0.000   290000.000
NPV = Sum of discounted cash flows                  
NPV Discount rate =   0.00              
MIRR is the rate at which NPV = 0   0.00              
MIRR=   18.54%              
Where                  
Discounting factor =   (1 + discount rate)^(Corresponding period in years)  
Discounted Cashflow=   Cash flow stream/discounting factor      
Compounding factor =   (1 + discount rate)^(time of last CF-Corresponding period in years)
Discounted Cashflow=   Cash flow stream*discounting factor