Question

Sugar Land 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 annual (Year 1 through 4) operating cash flows

	Year 1	Year 2	Year 3	Year 4
Tot Sales
Var. Cost
Depreciation
EBIT
Taxes
Net Income
Depreciation
OCF

Answer 1

Based on the given data, pls find below the workings for the same:

In addition, have computed NPV, IRR and Payback for the given project, to evaluate the project;

Computation of IRR: This can be computed using formula in Excel = IRR("range of cashflows", discounting factor%);

Computation of Net Present Value (NPV) based on the Disounted Cash flows; The Discounting factor is computed based on the formula: For year 0, the discounting factor is 1; For Year 1, it is computed as = Year 0 factor /(1+discounting factor%) = 1/(1+11%) = 0.9009; Year 2 = Yeaar 1 factor/(1+discounting factor %) = 0.9009/(1+11%) = 0.8116 and so on;

Next, the cashflows need to be multplied with the respective years' discounting factor, to arrive at the discounting cash flows;

The total of all the discounted cash flows is equal to its respective Project NPV of the Cash Flows;

Computation of Pay Back Period: Here, the period is computed for the project, based on cumulative discounted cash flows: If the cumulative value is less than or equal to zero, the period is considered as 12 months (it means that the net cumulative cash flow has not yet paid back the initial investment); Once the value turns positive in a particular year, the period for such year is observed at a proportion of actual discounted cash flow to the cumulative CF; This gives the period less than 12 months in such year; Once this is computed, total of all the years is taken and divided by 12, to arrive at the Payback period in no.of years.