Question

Bourque Enterprises is considering a new project. The project will generate sales of $1.6 million, $2 million, $1.9 million, and $1.4 million over the next four years, respectively. The fixed assets required for the project will cost $1.5 million and will be eligible for 100 percent bonus depreciation. At the end of the project, the fixed assets can be sold for $175,000. Variable costs will be 30 percent of sales and fixed costs will be $400,000 per year. The project will require NWC equal to 15 percent of sales that must be accumulated in the year prior to sales. The required return on the project is 11 and the tax rate is 21 percent.

What is the NPV of the project?

Answer 1

Profit & Loss Account for the question can be built as follows:

Values in $Mn	Year 1	Year 2	Year 3	Year 4
Sales	$1.60	$2.00	$1.90	$1.40
Gain from sale of fixed assets				$0.18
(-) Variable Costs - 30% Of Sales	$0.48	$0.60	$0.57	$0.42
(-) Fixed Costs	$0.40	$0.40	$0.40	$0.40
EBITDA	$0.72	$1.00	$0.93	$0.76
(-) Bonus Depreciation	$0.72
(-) Depreciation	$0.38	$0.38	$0.38	$0.38
PBT	($0.38)	$0.63	$0.56	$0.38
(-) Tax - 21% of PBT	$0.00	$0.13	$0.12	$0.08
PAT	($0.38)	$0.49	$0.44	$0.30

Based on the given sales & variable costs & fixed costs we can reach the EBITDA(Earnings before Interest, Tax, Depreciation & Amortization) reached above. Gain from sale of fixed assets can be removed from profit & loss account, on account of it being an extraordinary expense but bringing it into profit & loss account ensures we don't miss out on tax payment on it. Then, bonus depreciations allows us to get 100% benefit of capital expenses. After taking bonus depreciation in the first year, we are able to follow the normal depreciation schedule for all the years (assumed to be straight line depreciation of $1.5 Mn across 4 years coming up to $0.375 Mn each year).

Using these & tax rate of 21%, we reach every year's PAT.

Going forward, we will need to calculate each year's Free Cash flow to find project NPV.

Free Cash flow can be calculated by multiple ways. Below I have created it by adding Cash flow from Operations & Cash flow from Investment.

Below are the calculations for Cash flow from operations & Cash flow from investment. You will notice that we have removed gain from sale of fixed assets from PAT as it won't be classified as a Cash flow from operations line item but instead cash flow from investment line item.

Values in $Mn	Year 0	Year 1	Year 2	Year 3	Year 4
PAT		(0.38)	0.49	0.44	0.30
(+) Depreciation		1.10	0.38	0.38	0.38
(-) Gain from sale of fixed assets		0.00	0.00	0.00	0.18
(-) Net Working Capital Change	0.24	0.30	0.29	0.21	(1.04)
Cash Flow From Operations	(0.24)	0.42	0.58	0.60	1.54
Cash Flow from Investment	(1.50)				0.18
Free Cash Flow	(1.74)	0.42	0.58	0.60	1.71
NPV (@11%)	0.68

Hence, we reach NPV of $0.68 Mn for the project.