Question

RET Inc. currently has one product, low-priced stoves. RET Inc. has decided to sell a new line of medium-priced stoves. Sales revenues for the new line of stoves are estimated at $50 million a year. Variable costs are 60% of sales. The project is expected to last 10 years. Also, non-variable costs are $10,000,000 per year. The company has spent $4,000,000 in research and a marketing study that determined the company will lose (cannibalization) $10 million in sales a year of its existing low-priced stoves. The production variable cost of the existing low-priced stoves is $8 million a year.

The plant and equipment required for producing the new line of stoves costs $30,000,000 and will be depreciated down to zero over 30 years using straight-line depreciation. It is expected that the plant and equipment can be sold (salvage value) for $12,000,000 at the end of 10 years. The new stoves will also require today an increase in net working capital of $5,000,000 that will be returned at the end of the project.

The tax rate is 20 percent and the cost of capital is 10%.

1. What is the initial outlay (IO) for this project?

2. What is the annual Earnings before Interests, and Taxes (EBIT) for this project?                                    

3. What is the annual net operating profits after taxes (NOPAT) for this project?

4. What is the annual incremental net cash flow (operating cash flow: OCF) for this project?

5. What is the remaining book value for the plant at equipment at the end of the project?

6. What is the cash flow due to tax on salvage value for this project? Enter a negative # if it is a tax gain. For example, if your answer is a tax on capital gains of $3,004.80 then enter   -3,005 ; if your answer is a tax shelter from a capital loss of $1,000,20 then enter 1,000

7. What is the project's cash flow for year 10 for this project?

8. What is the Net Present Value (NPV) for this project?

Answer 1

1. Initial Outlay - It is Cost of Plant and Equipment required to start the project. i.e $ 30 Million + The working capital required at the beginning i.e $5 Million. SO Total Initial Outlay= $35 Million.

2. Calculation of EBIT. Details Sheet to calculate with the inforation given in this question.

Particulars	Ampunt in Millions
Sale	50
Less: Variable cost 60%	30
Contribution	20
Less Fixed Cost	10
Profit	10
Less Depreciation 30M/30	1
EBIT	9
Less taxes @20%	1.8
NOPAT	7.2

EBIT = $9 Million

3. NOPAT= $7.2 Million as per above sheet

4. Annual Incremental Cash Flows.

CAsh flows from current project NOPAT + Depreciation = 7.2+1 = 8.2 is Cash inflows from current project and Loss of revenue from current business ( 10M - 8M) x (1 - taxes) = 1.6 Million

So Incremental cash flows 8.2-1.6 = $6.6 Million

5. Remaining Book value of Plant is Simply the Gross block - Depreciation.

Plant Value	30m
Less Depriciation
1M for 10 yaers	10m
Reamining Book value	20m

6. Capital gain or Loss on Salvage Value

Sale value = 12M

Less: Book value = 20M

Capital Loss = 8M

So tax gain on capital loss 8M x 0.20 = 1.6M i.e. cash flow due to tax on salvage value.

7. Project Cash flow for 10th year

Realization of Salvage Value = 12M

Add: cash flow due to tax on salvage value = 1.6M

Add: Realizatio of Working capital = 5M

Total = 18.6M

8. NPV of the Project is Net present Value. Present Value of Cash inflows - Initial investment

6.6 x Cumulative Discount factor @10% for 10 years + 18.6 x PV factor @ 10% for 10th Year - 35

6.6 x 6.1446 + 18.6 x 0.3855 - 35

47.72 - 35 = +12.72 NPV