Question

Your company is considering a new 3-year project that requires an initial investment in equipment of $3 million. Prior to this, you had engaged a consultant to study the feasibility of the new project and after an extensive market survey, the consultant confirmed your belief that the project would be viable. Your company is charged $100,000 for the feasibility study. The equipment will be depreciated straight line to zero over the 3 years of its useful life. In addition, you will need to invest $180,000 in net working capital at the initiation of the project. You estimate that the project will produce sales of $3.5 million every year for 3 years, with costs of $1.5 million. The tax rate is 20%.

(a) Calculate the operating cash flow for this project.

(b) (i) Explain how depreciation increases the operating cash flow and what is the savings for the firm due to depreciation. (ii) Your colleague tells you that interest expense, if present, should be included in the calculation of operating cash flow because it is a significant expense and it is an actual cash outflow. Is he right? Explain.

(c) The equipment has a market value of $250,000 at the end of the project. What is the net salvage value? Should you include it in the calculation of the project's NPV? Show why or why not.

(d) The required return on this project is 12%. Taking into account all the above information, determine if you would recommend to invest in this project?

Answer 1

Solution to part (a)

Solution to part (b)(i)

Depreciation is a non-cash expenses and hence it increases the operaring cash flows. If there was no depreciation expenses, Net Income each yer would be higher at $ 2 MM. Higher Net Income would mean higher tax. Tax expenses each year would have been $ 0.40 MM. Thus net operating cash flows (in absence of depreciation) would have been $ 1.60 MM (Net Income less tax) instead of $ 1.80 MM currently. Thus there is tax savings of $ 0.20 MM per year to the firm due to depreciation which results in tax savings of $ 0,60 MM over 3 years.

Solution to part (b) (ii)

Interest expenses is cash expenses paid to lenders for financing the project. It is an important expenses and should be deducted while calculating net operating cash flows froom the project. Interest expenses will reduce the net operatting cash flows generated from the project each year.

Solution to part c

Solution to part (d)