Question

You just finished calculating the NPV of project A and found it to be $49,242. A concurrent project, which will use the same resources as project A is now before you as well. This is project B, which will require a $2M investment in an asset that will have a $1M salvage value at the end of the project. A total of $170,000 was invested in the consulting and research leading to the marketability of the product. Project B will generate annual sales of $1.5M and total costs of $1.1M. The firm’s cost of capital is 7.5%, its tax rate is 30%, and the CCA depreciation for this asset is 20%. Project B will trigger a net change in working capital of $130,000. The project will last 6 years. Calculate the NPV of this project and say clearly whether you would accept it. You must show your work to get full points. 12 points.

Answer 1

Project B would not accept because it gives negative NPV from the project which is calculated below.

Calculation of NPV of Project B:

NPV = sum of discounted cash flow = -$2,300,000.00+$325,756.04+$292,644.46+$264,490.14+$240,272.80 +$219,241.48+$842,050.23 = -$115,544.84

Sl No	Year	0	1	2	3	4	5	6
i	Sales (given)		$1,500,000	$1,500,000	$1,500,000	$1,500,000	$1,500,000	$1,500,000
ii	Total costs (given)		$1,100,000	$1,100,000	$1,100,000	$1,100,000	$1,100,000	$1,100,000
iii	Consulting & research expenses (Assumption 1)		$34,000	$34,000	$34,000	$34,000	$34,000
iv	EBITDA (i-ii-iii)		$366,000	$366,000	$366,000	$366,000	$366,000	$400,000
v	Depreciation (refer Wno 1)		$200,000	$160,000	$128,000	$102,400	$81,920	$65,536
vi	EBIT (iv-v)		$166,000	$206,000	$238,000	$263,600	$284,080	$334,464
vii	Tax @ 30% (vi*0.3)		$49,800	$61,800	$71,400	$79,080	$85,224	$100,339
viii	PAT (vi-vii)		$116,200	$144,200	$166,600	$184,520	$198,856	$234,125
ix	Consulting & research expenses (iii)		$34,000	$34,000	$34,000	$34,000	$34,000
x	Depreciation (v)		$200,000	$160,000	$128,000	$102,400	$81,920	$65,536
xi	Operating cashflow (viii+ix+x)		$350,200	$338,200	$328,600	$320,920	$314,776	$299,661
xii	Investment in asset (given)	-$2,000,000						$1,000,000
xiii	Investment in consulting & research (given)	-$170,000
xiv	Net change in working capital (given) (Assumption 2)	-$130,000
xv	Total cashflow (xi+xii+xiii+xiv)	-$2,300,000	$350,200	$338,200	$328,600	$320,920	$314,776	$1,299,661
xvi	Present value factor @ 7.5%	1.0000	1/1.075 = 0.9302	1/(1.075^2) = 0.8653	1/(1.075^3) = 0.8049	1/(1.075^4) = 0.7487	1/(1.075^5) = 0.6965	1/(1.075^6) = 0.6479
xvii	Discounted cashflow (xv*xvi)	-$2,300,000	$325,756.04	$292,644.46	$264,490.14	$240,272.80	$219,241.48	$842,050.23

Assumption 1 = Investment in consulting & research is allowed as deduction for tax purpose for 5 years. $170,000/5 = $34,000. Again assumed total costs exclude consulting & research expenses.

Assumption 2 = Net change in working capital in invested now. Assumed it will not be realised at the end of the project.

Wno 1:

Depreciation for year 1 =(Investment-salvage value)*20% = (2,000,000-1,000,000)*20% = 1,000,000*20% = 200,000

Depreciation for year 2 = (Investment-salvage value-depreciation for year 1)*20% = (2,000,000-1,000,000-200,000)*20% = 800,000*20% = 160,000

Depreciation for year 3 = (Investment-salvage value-accumulated depreciation)*20% = (2,000,000-1,000,000-200,000-160,000)*20% = 640,000*20% = 128,000

Depreciation for year 4 = (Investment-salvage value-accumulated depreciation)*20% = (2,000,000-1,000,000-200,000-160,000-128,000)*20% = 512,000*20% = 102,400

Depreciation for year 5 = (Investment-salvage value-accumulated depreciation)*20% = (2,000,000-1,000,000-200,000-160,000-128,000-102,400)*20% = 409,600*20% = 81,920

Depreciation for year 6 = (Investment-salvage value-accumulated depreciation)*20% = (2,000,000-1,000,000-200,000-160,000-128,000-102,400-81,920)*20% = 327,680*20% = 65,536