Question

A colleague of yours is planning to start a small, plastic components manufacturing business. He has invited you to be a partner. Best estimates for the total depreciable capital for equipment which includes a compounder and extruder is $500,000. Expected sales amount to $250,000 annually and total manufacturing costs without depreciation was estimated to be about $96,500 yearly. If equipment can be purchased and installed in one year and the project has a ten year life, perform a complete discounted cash flow analysis and make a decision if you should invest or not. Assume straight-line depreciation for ten years at which point the equipment salvage value will be zero. Also assume that you can invest at 10% interest in other opportunitites for comparison.

Answer 1

Initial outlay = $500,000

Interest Rate = 10%

Operating Cash flows

	Year 0	Year 1	Year 2	Year 3	Year 4	Year 5	Year 6	Year 7	Year 8	Year 9	Year 10
Initial outlay	($500,000)
Sales		$250,000	$250,000	$250,000	$250,000	$250,000	$250,000	$250,000	$250,000	$250,000	$250,000
Operating Expenses		($96,500)	($96,500)	($96,500)	($96,500)	($96,500)	($96,500)	($96,500)	($96,500)	($96,500)	($96,500)
Depriciation(1)		($50,000)	($50,000)	($50,000)	($50,000)	($50,000)	($50,000)	($50,000)	($50,000)	($50,000)	($50,000)
Operating income before taxes		$103,500	$103,500	$103,500	$103,500	$103,500	$103,500	$103,500	$103,500	$103,500	$103,500
Taxes		0	0	0	0	0	0	0	0	0	0
Operating income after taxes		$103,500	$103,500	$103,500	$103,500	$103,500	$103,500	$103,500	$103,500	$103,500	$103,500
Add back: Depreciation		$50,000	$50,000	$50,000	$50,000	$50,000	$50,000	$50,000	$50,000	$50,000	$50,000
Terminal year after tax. non-operating cash flows	($500,000)	$153,500	$153,500	$153,500	$153,500	$153,500	$153,500	$153,500	$153,500	$153,500	$153,500

NPV = -500,000 + 153,500 / (1 + 0.10) + 153,500 / (1 + 0.10)2 + 153,500 / (1 + 0.10)3 + 153,500 / (1 + 0.10)4 + 153,500 / (1 + 0.10)5 + 153,500 / (1 + 0.10)6 + 153,500 / (1 + 0.10)7 + 153,500 / (1 + 0.10)8 + 153,500 / (1 + 0.10)9 + 153,500 / (1 + 0.10)10

NPV = 440,573

Sicne, the NPV is positive, it is prudent to invest.

Notes

(1) Calculation of depreciation

Equipment cost = 500,000

Depreciation rate - 10%

Yearly depreciation = 500,000 * 10% = 50,000