Question

Questions #(1) to # (3) are based on the following information.

MacDonald Publishing is considering entering a new line of business. In analyzing the potential business, their financial staff has accumulated the following information:

• The new business will require a capital expenditure of $5 million at t = 0. This expenditure will be used to purchase new equipment.
• This equipment will be depreciated according to the following depreciation schedule:

Year                   Rate

1                      0.33

2                      0.45

3                      0.15

4                      0.07

• The equipment will have no salvage value after four years.
• If MacDonald goes ahead with the new business inventories will rise by $600,000 at t = 0, and its accounts payable will rise by $300,000 at t = 0. This increase in net operating working capital will be recovered at t = 4.
• The new business is expected to have an economic life of four years. The business is expected to generate sales of $4 million each year from t = 1 to t=4. Each year, operating costs excluding depreciation are expected to be 80 percent of sales.
• The company’s tax rate is 40 percent.
• The company’s weighted average cost of capital is 10 percent.
• The company is very profitable, so any accounting losses on this project can be used to reduce the company’s overall tax burden.

(1).    How much is the total initial investment outlay (total net cash flow at t = 0) and terminal cash flow at t=4?

(2).    How much is the Operating Cash Flow at t=1,t=2, t=3, and t=4?

(3).   What is the expected net present value (NPV) of the new business?

Answer 1

(1)Total Initial outlay =Purchase price of asset+installation and modification costs+shipping /transaportation cots+change in working capital

Purchase price =$5,000,000 Increase in working capital=Increase in invetory =$600,000-increase in accounts payable=$300,000 we get $300,000

Initial outlay =$5,000,000+$300,000 =-$5,300,000(- sign to denote it as outflow)

Depreciation base will be $5,000,000

terminal cashflow =Salvage value -(Salvage value-book value) *tax rate +working capital recovered

Salvage value =0 Working capital recovered =$300,000

Terminal cashflow =$300,000

(2)operating cash flow =change in revenue+/-change in expense +/- tax depreciation charge+/-tax add back tax depreciation

Change in revenue =$4,000,000 change in expense =$3,200,000 tax =40%

Operating cash flow (T=1)=$4,000,000 Less expenses =$3,200,000 Less tax depreciation (5,000,000*.33) that is 1,650,000 we get -850,000 Add back tax refund at 40% 340,000 we get -510,000 add tax depreciation $1,650,000 we get $1,140,000

Operating cash flow (t=2) =$4,000,000 less expenses =$3,200,000 Less tax depreciation($5,000,000*.45) that is $2,250,000 we get -$1,450,000 add back tax refund @40%=$580,000 we get -$870,000 add back tax depreciation $2,250,000 we get $1,380,000

operating cash flow (t=3)=$4,000,000 less expenses =$3,200,000 less tax depreciation ($5,000,000*.15) that is $750,000 we get $50,000 less tax @40%=20,000 we get $30,000 add back tax depreciation $750,000 we get $780,000

Operating cash flow (t=4) =$4,000,000 less expenses =$3,200,000 less tax depreciation ($5,000,000*.07) that is $350,000 we get $450,000 less tax @40% that is $180,000 we get $270,000 add back tax depreciation $350,000 we get $620,000+terminal cash flow =$300,000 we get $920,000

(3)NPV =Pv of inflows -initial Outlay

Discount rate =10%

Pv of inflows =$1,140,000*.9091+$1,380,000*.8264+$780,000*.7513+$920,000*.6830

=$1,036,374+$1,140,432+$586,014+$628,360 we get $3,391,180

Initial Outflow =$5,300,000

NPV =$3,391,180-$5,300,000 =-$1,908,820