Question

The K-State Megastore is considering a new 6-year project to produce a new flag line. The equipment necessary would cost $1.37 million and be depreciated using straight-line depreciation to a book value of zero. At the end of the project, the equipment can be sold for 15 percent of its initial cost. The company believes that it can sell 25,500 flags per year at a price of $68 and variable costs of $28 per flag. The fixed costs will be $435,000 per year. The project will require an initial investment in net working capital of $209,000 that will be recovered at the end of the project. The required rate of return is 11.1 percent and the tax rate is 40 percent. What is the NPV?

• $660,397

• $968,299

• $463,633

• $561,495

• $402,852

Answer 1

Initial investment = Equipment cost + Working capital = $1,370,000 + $209,000 = $1,579,000 (A)

Calculation of yearly cash flow :

PV of these cash flow would be, PV annuity factor of (11.1% for 6 years) :

PVF factor calculated by the following formula would be 4.22

Hence the present value would be 4.22*442,333 = $1,865,929 (B)

In the last year, the company will recover the amount of working capital back $209,000. Also the sale value of machine would be 15%, i.e. 15%*1,370,000 = 205,500. on this tax of 40% will be paid as this is all profit for the company. After tax amount of sale would be 205,00* (1-40%) = 123,300

Thus, total recovery at year end 6 would be 123,300 + 209,000 = 332,300

PV of this amount would be = 332,300 / (1+11.1%)^6 = 176,703.84 (C)

NPV would be (B+C-A) =$1,865,929 + 176,703.84 -$1,579,000 = $463,633

Yearly depriciation Cost of Equipment Life of project Yearly 1,370,000 6 228,333 Amount 25,500 A 68 Particulars No. of flags sold Sale price Cost Net sales price Total sales Less: Fixed cost 28 40 B 1,020,000 A*B 435,000 Total profit Less Tax@40% Add Depreciation tax shield (228,333*40%) 585,000 234,000 91,333 Net cash flow every year 442,333