Question

Quad Enterprises is considering a new three-year expansion project that requires an initial fixed asset investment of $2.29 million. The fixed asset qualifies for 100 percent bonus depreciation in the first year. The project is estimated to generate $1,810,000 in annual sales, with costs of $700,000. The project requires an initial investment in net working capital of $450,000, and the fixed asset will have a market value of $480,000 at the end of the project.

  

a.	If the tax rate is 25 percent, what is the project’s Year 0 net cash flow? Year 1? Year 2? Year 3?
b.	If the required return is 12 percent, what is the project's NPV?

Answer 1

(a)
Calculation of net Cash flow at year 0
Fixed Asset investment						-$2,290,000.00
Investment in NWC at begining of year						-$450,000.00
						________________
Net cash flow at Year 0						-$2,740,000.00
						________________
Calculation of Net Cash Inflow at year 1 to year 3
				Year 1	Year 2	Year 3
Sales				1810000.00	1810000.00	1810000.00
Less : cost				-700000.00	-700000.00	-700000.00
Less : Bonus depreciation allowed				-2290000.00	0.00	0.00
in year 1				_____________________________________
Annual Profit				-1180000.00	1110000.00	1110000.00
Less : Tax	25%			295000.00	-277500.00	-277500.00
				(Note 2)
				_____________________________________
Profits after tax				-885000.00	832500.00	832500.00
Add : Depreciation				2290000.00	0.00	0.00
(Note 1)
Add : Net working capital recovered at end				-	-	450000.00
Add : Sale value of equipment at end				-	-	480000.00
Less : Tax payable on capital gain
(As whole value is depreciated, Tax @ 25 % will be
Payable on capital gain) 480000*25%						-120000.00
				_____________________________________
Net cash flows				$1405000.00	$832500.00	$1642500.00
				_____________________________________
Net cash flow at year 0			-$2,740,000.00
Net cash flow at year 1			$1,405,000.00
Net cash flow at year 2			$832,500.00
Net cash flow at year 3			$1,642,500.00
(b) Calculation of NPV of project
Year	Cash flows		P.V.F. @ 12%		P.V. of cash flows
0	-$2740000.00		1.000000000		-$2,740,000.00
1	1405000		0.892857143		$1,254,464.29
2	832500.00		0.797193878		$663,663.90
3	1642500.00		0.711780248		$1,169,099.06
					______________
					$347,227.25
					______________
NPV of Project is    $ 347,227.25. So Project should be accepted.
Note 1 : Depreciation is considered for tax purpose. So it is deducted. But it is not a real cash flow. So It will be added back to profit after Tax.
Note 2 : After deducting depreciation, there is loss. So tax benefit of loss shall be considered and added to Cash inflows as it will generate savings in tax payable.