Question

Arnold Inc. is considering a proposal to manufacture high-end protein bars used as food supplements by body builders. The project requires use of an existing warehouse, which the firm acquired three years ago for $1 million and which it currently rents out for $120,000. Rental rates are not expected to change going forward. In addition to using the warehouse, the project requires an up-front investment into machines and other equipment of $1.4m. This investment can be fully depreciated straight-line over the next 10 years for tax purposes. However, Arnold Inc. expects to terminate the project at the end of eight years and to sell the machines and equipment for $500,000. Finally, the project requires an initial investment into net working capital equal to 10% of predicted first-year sales. Subsequently, net working capital is 10% of the predicted sales over the following year. Sales of protein bars are expected to be $4.8 million in the first year and to stay constant for eight years. Total manufacturing costs and operating expenses (excluding depreciation) are 80% of sales, and profits are taxed at 30%. (10Marks)

a.   What are the free cash flows of the project?

b.   If the cost of capital is 15%, what is the NPV of the project?

Answer 1

The question is solved based on the following assumptions :-

• working capital wiil be recovered fully at the end of 8 years.
• We can rent the warehouse at $1,20,000 after 8 year also.

A) free cash flow (FCF) = {EBIT (1 – tax) }+ Depreciation – capital expentiture – Change in working capital

Calculation of FCF in year 0

working capital in y0 = 10% of predicted first-year sales = 4.8 million*10%

= 0.48 million

FCF = -1.4 -0.48 = -1.88

Calculation of FCF in year 1- 7

Calculation of FCF in year 8

free cash flow (FCF) = {EBIT (1 – tax) }+ Depreciation – capital expentiture – Change in working capital

= $0.63m + [$0.5m – 0.30 x ($0.5m – $0.28m)] + $0.48m = $1.544m

Here the book value of the machinery is still $0.28m at the time of sale, and tax applicable only on the difference between the sale price ($0.5m) and the book value.

There is no tax on the working capital recovery.

B) calculation of NPV

The NPV = present value of the FCFs in years 0 to 8