Question

Your company is considering launching a new product. Designing the new product has already cost $500,000. The company estimates that it will sell 750,000 units per year of $3.2 per unit and variable non-labor costs will be $1 per unit. Production will end after year 3. New equipment costing $1 million will be required. The equipment will be depreciated to zero using the 7-year MACRS schedule. You plan to sell the equipment for book value at the end of year 3. Your current level of working capital is $300,000. The new product will require the working capital to increase to a level of $380,000 immediately, then to $400,000 in year 1, in year 2 the level will be $350,000, and finally in year 3 the level will return to $300,000. Your tax rate is 30%. The discount rate for this project is 11%. Do the capital budgeting analysis for this project and calculate its NPV.

Answer 1

		ANALYSIS OF CASH FLOWS
		Design Cost of $500,000 is a sunkcost and not relevant for this analysis
		Initial Cash Flow:
		Cost of Equipment	$1,000,000
		Increase in working capital=380000-300000	$80,000
	IC	Total Initial outlay	$1,080,000
		DEPRECIATION EXPENSES
		Year	1	2	3
	A	7 Year MACRS Depreciation Rate	14.29%	24.49%	17.49%
	B=1000000*A	Annual Depreciation	$142,900	$244,900	$174,900
	C	Accumulated Depreciation	$142,900	$387,800	$562,700
	D=1000000-C	Book Value at end of year	$857,100	$612,200	$437,300
		Annual Cash Flow:
	N	Year	1	2	3
	a	Sales in Units	750,000	750,000	750,000
	b=a*$3.2	Sales Revenue	$2,400,000	$2,400,000	$2,400,000
	c=a*$1	Variable Cost	$750,000	$750,000	$750,000
	d	Depreciation expenses	$142,900	$244,900	$174,900
	e=b-c-d	Profit before tax	$1,507,100	$1,405,100	$1,475,100
	f=e*30%	Tax expense/(Savings)	$452,130	$421,530	$442,530
	g=e-f	After tax profit	$1,054,970	$983,570	$1,032,570
	h	Add: Depreciation (non cash expense)	$142,900	$244,900	$174,900
	i=g+h	Operating Cash Flow	$1,197,870	$1,228,470	$1,207,470
	j	Working Capital Cash Flow	($20,000)	$50,000	$50,000
	k	Salvage Value(Book Value at end of year3)			$437,300
	l=i+j+k	TotalCash Flow	$1,177,870	$1,278,470	$1,694,770	SUM
	PV=l/(1.11^N)	Present Value of Cash Flow(discount11%)	$1,061,144	$1,037,635	$1,239,201	$3,337,980
	SUMPV	Sum of PV of Cash Inflows	$3,337,980
	NPV=SUMPV-IC	Net Present Value=Sum of PV of Cash inflows-Initial Outlay
	NPV=SUMPV-IC	Net Present Value=3337980-1080000=	$2,257,980