Question

"ABC Media is considering a proposal to enter a new line of business. In reviewing the proposal, the company’s CFO is considering the following facts: The new business will require the company to purchase additional fixed assets that will cost $2,500,000 at t=0. For tax and accounting purposes, these costs will be depreciated to 0 using straight-line depreciation. The equipment will be housed in the firm’s existing facility (built 10 years ago). The facility originally cost $5,000,000. If it is not used for the project, it can be sold now for $800,000 (after-tax value of the land). If it is used for the project, it will have no value at the end of 4 years. At the end of four years, the company will get out of the business and will sell the fixed assets for $300,000. A major factor in the decision to go ahead with the project was the results of its testing program. Two years ago, the company spent $500,000 in its test program for this project. The project will require a $400,000 increase in inventory and a $200,000 increase in accounts payable at t=0. All working capital will be recovered in the last (terminal) year of the project. The tax rate is 40%. The new business is expected to generate $10 million in sales in year 1. The operating costs, excluding depreciation, will be $4 million in year 1. Revenues and costs will increase at the inflation rate of 3% starting in year 2. The discount rate is 10%. What is the NPV of this project?"

Answer 1

NPV of the project = 9,445,503.18

Calculations:

Note: Test program cost is not included in free cash flow as it is a sunk cost.