Question

Imperium Chemicals Limited (ICL) is considering a new production project (all figures in $000s). The machine involved has an installed purchase price of $180. The machine will be depreciated straight-line over its life of 3 years, at the end of which time it will have a salvage value of $40. Cash sales from this new project will be $200 per year and cash costs will run to $110 per year. The firm will need to invest $70 in inventory when the project is undertaken, and it is expected that this would be fully recovered at the end of the project. The appropriate discount rate for all cash flows is 8% and the corporate tax rate is 40%.

QUESTION 1 The initial investment outlay on this project is:

QUESTION 2 The after-tax cash flows in both Years 1 and 2 are:

QUESTION 3 The after-tax cash flow at the end of Year 3 will be:

QUESTION 4 The net present value (NPV) of this project is:

Answer 1

Answer 1) The following information is required to calculate the initial investment outlay on this project

1. The purchase price of the machine is $180,000
2. The net-working capital in the form of inventory required is $70,000

Initial investment = purchase price of machine + net working capital

=$180,000 + $70,000

=$250,000

Following details are required to calculate the net present value

• The deprecation method followed is the straight-line method
• The life of the machine is 3 years
• The salvage value is $40,000

Depreciation expense per year = (purchase price of machine - salvage value) / life of machine

= ($180,000 - $40,000) /3

=$140,000 / 3

=$46,666.67

• The projected sales revenue per year is $200,000
• The projected costs per year are $110,000
• The tax rate is 40%
• The discount rate is 8%

The net present value schedule is prepared below

	Year 0	Year 1	Year 2	Year 3
Purchase Price	-$180,000
NOWC	-$70,000
Sales revenues		$200,000	$200,000	$200,000
Costs		-$110,000	-$110,000	-$110,000
Depreciation expense		-$46,667	-$46,667	-$46,667
Operating Income		$43,333	$43,333	$43,333
Taxes (@40%)		-$17,333	-$17,333	-$17,333
After - Tax operating income		$26,000	$26,000	$26,000
Add back depreciation		$46,666.67	$46,666.67	$46,666.67
Operating Cash flow		$72,666.67	$72,666.67	$72,666.67
Termination cash flows
Before tax salvage proceeds				$40,000
tax on salvage proceeds				-$16,000
NOWC recapture				$70,000
Project cash flows	-$250,000	$72,666.67	$72,666.67	$166,666.67
Present Value factor @8%	1	0.925925926	0.85733882	0.793832241
Present value of cash flows	-$250,000	$67,283.95	$62,299.95	$132,305.37
cumulative present value cash flows	-$250,000	-$182,716.05	-$120,416.10	$11,889.28

Answer 2)   The after-tax cash flows in both Years 1 and 2 are $72,666.67

Answer 3 ) The after-tax cash flow at the end of Year 3 will be $166,666.67

Answer 4)   The net present value (NPV) of this project is a positive amount of $11,889.28