Question

An analyst brings you a project. She expects there to be operating cash flow of $500,000 for the first year, and then it will decease by 10% for six more years. You need to contribute $70,000 in net working capital. You will salvage 50% of that back when the project ends in seven years. You need to purchase $1,800,000 of equipment at the beginning and then another $100,000 in year three. No salvage for equipment. You know your company’s WACC is 9% and this project is very similar to your company’s operations. What is the NPV of this project and should you do it?

Answer 1

NET PRESENT VALUE:

NPV is the net amount of discounted cash inflow and discount cash outflow of the project. This helps the investor whether to invest in a particular project or not. If the NPV is positive, investor should go for the project. If the NPV is negative, investor should not invest in the project.

CALCULATION OF CASH FLOWS:

1. Calculation of Initial Cash Outflow

SL No	Particulars	Amount in $
1	Working capital requirement	$ 70,000.00
2	Equipment purchase cost	$ 1,800,000.00
Total initial cash outflow	$ 1,870,000.00

2. Calculation of yearly cash inflow from the project:

Year	Particulars	Amount in $
1	Operating cash inflow for the first year	$ 500,000.00
2	Operating cash inflow for the second year(decrease of 10%)	$ 450,000.00
3	Operating cash inflow for the third year(decrease of 10%)	$ 405,000.00
Additioanl equipment purchased(Cash outflow	$ -100,000.00
Net Cash inflow for the third year	$ 305,000.00
4	Operating cash inflow for the fourth year(decrease of 10%)	$ 364,500.00
5	Operating cash inflow for the fifth year(decrease of 10%)	$ 328,050.00
6	Operating cash inflow for the sixth year(decrease of 10%)	$ 295,245.00
7	Operating cash inflow for the seventh year(decrease of 10%)	$ 265,720.50
Salvage of working capital (50% of $ 70,000)	$ 35,000.00
Total cash inflow for the seventh year	$ 300,720.50

Note 1: Operating cash inflow for the first year is $ 500,000.00. We have considered that there is a decline of 10% of operating cash inflow for the seond year is $ 50,000.00. Hence the cash inflow for the second year is $ 405,000.00. We have taken 10% of 405,000 as the decline in cash flow for the third year and so on.

Note 2: We have considered that there is an additional equipment is purchased for $ 100,000.00. We assume that this is purchased at the third year end and cash outflow was at the third year end. Hence we considered the additions in the third year. However, we can assume that the payment for the additional equipment is made in the beginning of third year, then we should show the additional equipment in the second year. Both assumptions are valid. However we assume that the cash outflow for additional equipment is made at the end of third year.

CALCULATION OF NET PRESENT VALUE

Year	Cash Flow	Discount Factor@09%	Discounted Cash Flow
0	$ (,1870,000.00)	1	$ (1,870,000.00)
1	$ 500,000.00	0.9174	$ 458,700.00
2	$ 4,50,000.00	0.8417	$ 378,765.00
3	$ 3,05,000.00	0.7722	$ 235,521.00
4	$ 3,64,500.00	0.7084	$ 258,211.80
5	$ 3,28,050.00	0.6499	$ 213,199.70
6	$ 2,95,245.00	0.5963	$ 176,054.59
7	$ 3,00,720.50	0.547	$ 164,494.11
Net Present Value	$ 14,946.20

Note 3: For discount factor at the rate of 09%, please refer the present value table.

CONSCLUSION AND RECOMMENDATION

Net Present Value of the project is positive. Hence the project can be taken up.