Question

The Dolphin Corporation, a firm in the 40 percent marginal tax bracket with a 9 percent cost of capital, is considering a new project. This project involves the introduction of a new product. This project is expected to last 4 years and then to be terminated. Cost of new plant and equipment is $990,000. Shipping and installation costs are $10,000. The company needs to increase its working capital requirement. There will be an initial inventory requirement of $15,000 just to start the production. Out of this amount, the company can owe money in the form of account payable. The payable will increase by $3,000. All the investment in working capital is paid at the termination of the project at year 4. The company expects to sell 27,000 units per year in four years. Sales price per unit is $25 per year. Total variable cost of productions is $10 per unit.    At the end of 4th year, the equipment should have a market value, which equals to salvage value because book value of the equipment is zero, of $50,000. The assets would be depreciated under MACRS with 3- year life. Year 1 depreciation rate is 33%, year 2 is 45%, year 3 is 15%, and year 4 is 7%.

Questions:

a. Given the information, fill in the excel work sheet to estimate the net cash flows of the project.

b. Determine the NPV, IRR, and payback period of the project.

c. What is your recommendation about the project?

Answer 1

Total cost of equipment = purchase cost + installation cost

Net investment in working capital = investment in inventory - accounts payable

Operating cash flow (OCF) each year = income after tax + depreciation

profit on sale of equipment at end of year 4 = sale price - book value

book value is zero as the equipment is fully depreciated.

after-tax salvage value = salvage value - tax on profit on sale of equipment

NPV and IRR are calculated using NPV and IRR functions in Excel

Payback period is the time taken for the cumulative cash flows to equal zero

Payback period = 2 + (cash flow required in year 3 for cumulative cash flows to equal zero / year 3 cash flow) = 2 + ($214,000 / $303,000) = 2.71 years

NPV is $143,776

IRR is 15.62%

It is recommended to accept the project as the NPV is positive and the IRR is higher than the cost of capital