Question

Company is considering adding a new line to its product mix, and the capital budgeting analysis is being conducted by a MBA student. The production line would be set up in unused space (Market Value Zero) in Sugar Land’ main plant. Total cost of the machine is $350,000. The machinery has an economic life of 4 years and will be depreciated using MACRS for 3-year property class. The machine will have a salvage value of $35,000 after 4 years.

The new line will generate Sales of 1,750 units per year for 4 years and the variable cost per unit is $110 in the first year. Each unit can be sold for $210 in the first year. The sales price and variable cost are expected to increase by 3% per year due to inflation. Further, to handle the new line, the firm’s net working capital would have to increase by $30,000 at time zero (No change in NWC in years 1 through 3 and the NWC will be recouped in year 4). The firm’s tax rate is 40% and its weighted average cost of capital is 11%.

**** Estimate the after tax salvage cash flow

*******Estimate the net cash flow of this project

Year zero

Year 1

Year 2

Year 3

Year 4

Estimate the NPV, IRR, MIRR, and profitability Index of the project.

Answer 1

a.

	Year 1	Year 2	Year 3	Year 4
Depreciation	$ 116,655	$ 155,575	$ 51,835	$ 25,935

b.

Year	Year 1	Year 2	Year 3	Year 4
Total Sales	$ 367,500	$ 378,525	$ 389,881	$ 401,577
Total Variable Costs	192,500	198,275	204,223	210,350

c.

	Year 1	Year 2	Year 3	Year 4
Total Sales	$ 367,500	$ 378,525	$ 389,881	$ 401,577
Total Variable Costs	192,500	198,275	204,223	210,350
Depreciation	116,655	155,575	51,835	25,935
EBIT	58,345	24,675	133,823	165,292
Taxes	23,338	9,870	53,529	66,117
Net Income	35,007	14,805	80,294	99,175
Depreciation	116,655	155,575	51,835	25,935
OCF	$ 151,662	$ 170,380	$ 132,129	$ 125,110

d. After tax salvage cash flow = $ 35,000 * ( 1 - 0.4 ) = $ 21,000.

e. NPV : $ 107,529

	Year 0	Year 1	Year 2	Year 3	Year 4
Net CF of the project	$ ( 380,000)	$ 151,662	$ 170,380	$ 132,129	$ 176,110

f.

	Year 0	Year 1	Year 2	Year 3	Year 4
Net CF of the project	$ ( 380,000)	$ 151,662	$ 170,380	$ 132,129	$ 176,110
PV factor at 11 %	1.0000	0.9009	0.8116	0.7312	0.6587
Present Values	(380,000)	136,632	138,280	96,613	116,004
NPV	$ 107,529

g. Profitability Index ( PI ) = Present Value of Cash Inflows / Present Value of Cash Outflows = $ 487,529 / $ 380,000 = 1.2830