Question

Your company, VZ, is evaluating the proposal of expanding FiOS Internet, Voice and TV service coverage to Western New York. The expansion project requires a new system costs $108,000, and it would incur another installation and configuration expense of $12,500. The system falls into the MACRS 3-year class, and it would be sold after 3 years for $65,000. The project would require an increase in net working capital (Labor, Office Leasing) of $5,500. The project is expected to generate additional revenue of $44,000 each year for 3 years. Verizon’s marginal tax rate is 36%.

1. What is the investment outlay of the system for capital budgeting purposes? (i.e. What is Year 0 net cash flow?)

2. What are the incremental operating cash flows in Year 1, 2, and 3?

3. What is the terminal cash flow in Year 3?

4. If the project’s required rate of return is 12%, should the project be pursued? What if the required rate of return is 18%? What if the required rate of return is 8%?

5. How would different financing strategies affect your decision on the profitability of the project?

Answer 1

1:  Initial outlay = 108000+12500 = - 120,500

2: Operating cash flows

OCF		MACRS 3 year
Year	Cash flows	Depreciation	EBIT=Cash flow+depreciation	Tax=EBIT*tax	PAT=EBIT-Tax	OCF=PAT+ Depreciation
1	44000	-40162.65	3837.35	-1381.4	2455.904	42619
2	44000	-53562.25	-9562.25	3442.4	-6119.84	47442
3	44000	-17846.05	26153.95	-9415.4	16738.528	34585

3:

Salvage
Purchase price	120500
Less: Depreciation	-111571
Closing book value	8929.1
Selling price	65000
Gain/(loss)	56071
Tax/ Saving	-20186
Net salvage	44814

terminal cash flow = Incremental cash flow+Net salvage + Working capital

= 34585+5500+ 44814

= 84899.04

4: NPV at 12% =

10302.54

NPV at 18%=

-4138.01

NPV at 8%=

21531.44

5: Different financing strategies will change the cost of capital. Higher debt will reduce the WACC to a certain extent which will change the NPV of the project.

WORKINGS