Question

Bayside Industries Inc. is evaluating an expansion project to establish its presence in a key market for its products. Your have collected the following data on the proposed project:

- The project requires $25 million in initial capital investment, and will have an economic life of 5 years. The investment will be straight-line depreciated down to a book value of zero at the end of 5 years. The investment is expected to be salvaged for $5 million at the end of 5 years.

- The projected sales are $20 million per year from year 1 through year 5, variable costs are 50% of annual sales, and fixed costs are $3 million per year.

- The corporate tax rate is 20%.

- The weighted average cost of capital applicable to the proposed project is 8%.

- Ignore investment in net working capital.

please show your working:

(a) Please compute the cash flow from assets for each year. ("cash flow from assets" is the same as " free cash flow")

(b) What is the NPV of the project?

(c) If the projected annual sales decrease by 5% to $19 million per year, how much would the project's NPV change?

Answer 1

a:

Free cash flow can be calculated as shown

	Year 0	Year 1	Year 2	Year 3	Year 4	Year 5
Cost of machine	-25					5
Sales Revenue		20	20	20	20	20
variable cost		10	10	10	10	10
Fixed cost		3	3	3	3	3
Depreciation		5	5	5	5	5
Profit		2	2	2	2	2
minus tax @20%		0.4	0.4	0.4	0.4	0.4
Profit after tax		1.6	1.6	1.6	1.6	1.6
Add Depreciation		5	5	5	5	5
FCF	-25	6.6	6.6	6.6	6.6	11.6
NPV	4.75

calculate operating profit and calculate profit after tax. After this add depreciation( 25/5) to the profita after tax to calculate free cashflow.

b:

npv can be calculated with a discount rate of 8% and present value of all the cashflows discounted at 8% using npv formula in excel. npv= 4.75 million dollars

c:

If sales is decreased to 19 million npv is as shown below

	Year 0	Year 1	Year 2	Year 3	Year 4	Year 5
Cost of machine	-25					5
Sales Revenue		19	19	19	19	19
variable cost		9.5	9.5	9.5	9.5	9.5
Fixed cost		3	3	3	3	3
Depreciation		5	5	5	5	5
Profit		1.5	1.5	1.5	1.5	1.5
minus tax @20%		0.3	0.3	0.3	0.3	0.3
Profit after tax		1.2	1.2	1.2	1.2	1.2
Add Depreciation		5	5	5	5	5
FCF	-25	6.2	6.2	6.2	6.2	11.2
NPV	3.16

ie: npv reduced to 1.6 million

Note: Year 0 ; investment cost of 25 million cash outflow; hence negative

Year 1 to 5: operating profit is calculated( sales - fixedcost- varaiable cost- depreciation)

variable cost=.5*sales(given) ; depreciation= (25-0)/5 ---straightline method

reduce tax from operating profit; then add depreciation to get free cashflow

salvage value of 5 million to be added in year 5 in cashflows

calculate all the cashflow to present value by formula CF/[ (1+8%)^ year] ; add all the present cashflows to get npv