Question

Please answer the following questions. Please write all your work. You will be graded on your process, NOT on achieving the correct answer. Please staple all pages together. Include your name on every page.

1) Wacky Widgets, Incorporated is considering a new three-year expansion project to make new Widgets. It requires an initial fixed investment of $2.7 million. The fixed asset will be depreciated straight-line to zero over its three-year tax life, after which it will be sold for $50,000 to a scrapyard. The fixed asset will take 2 years to install, so revenue will begin in year 2.

The project is estimated to generate $2,800,000 in annual sales, with variable costs of 40 percent. There are no fixed costs, and working capital requirements are 5% of annual revenues. The tax rate is 35 percent and the required rate of return is 15 percent. The risk-free rate is 9 percent. Your firm requires a payback period of 3 years to approve a project.

The Widget produced by this product will often go to the same customers as the Bidget, another product produced by Wacky Widgets. They will often be shipped in the same package as another product the firm produces. It will not reduce the overhead on producing Widgets, but it will reduce the cost of shipping Bidgets by $20,000 per year in years 2 - 4.

a) Construct a full pro-forma statement for this project’s projected incremental cash flows.

b) What is the payback period? Based on this decision rule, should you do the project?

c) What is the discounted payback period? Based on this decision rule, should you do the project?

d) What is the NPV? Based on this decision rule, should you do the project?

e) What is the IRR? Based on this decision rule, should you do the project? f) What is the profitability index? Based on this decision rule, should you do the project? g) Should you approve the project? What decision rule are you using to make your final decision?

Answer 1

		Annual Depreciation	$900,000	(2700000/3)
		Tax Rate	0.35
		Annual Depreciation tax shield	$315,000	(900000*0.35)
		Cash Flow from Salvage:
		Salvage value	$50,000
		Tax on gain on salvage	$17,500	(50000*0.35)
		After tax cash flow	$32,500	(50000-17500)
		Present Value (PV) of Cash Flow:
		(Cash Flow)/((1+i)^N)
		i=Discount Rate=Required Rate of return=15%=0.15
		N=Year of Cash Flow
	N	Year	0	1	2	3	4
	A	Initial fixed investment	($2,700,000)
	B	Revenue			$2,800,000	$2,800,000	$2,800,000
	C=0.4*B	Variable cost			$1,120,000	$1,120,000	$1,120,000
	D=B-C	Operating income before tax			$1,680,000	$1,680,000	$1,680,000
	E=0.35*D	Taxes			$588,000	$588,000	$588,000
	F=D-E	After tax Income			$1,092,000	$1,092,000	$1,092,000
	G	Depreciation tax shield			$315,000	$315,000	$315,000
	H=F+G	Operating Cash Flow			$1,407,000	$1,407,000	$1,407,000
	I	Working capital cash flow		($140,000)			$140,000
	J	Terminalcash flow on salvage					$32,500
	K	Savings in shipping cost			$20,000	$20,000	$20,000
	L=A+H+I+J+K	Net Cash Flow	($2,700,000)	($140,000)	$1,427,000	$1,427,000	$1,599,500
		Cumulative Cash Flow	($2,700,000)	($2,840,000)	($1,413,000)	$14,000	$1,613,500	SUM
	M=L/(1.15^N)	Present Value (PV)of Cash Flow	($2,700,000)	($121,739)	$1,079,017	$938,276	$914,519	$110,073
		Cumulative Present Value of cash flow	($2,700,000)	($2,821,739)	($1,742,722)	($804,446)	$110,073
		Pay back Period =Period at which cumulative cash flow=Zero
		Payback Period =2+(1413000/1427000)=	2.99	YEARS
		Yes,the project should be accepted
		It meets the payback criteria of 3 years
		Discounted Payback Period=Period at which cmulative present value of cash flow =Zero
		Discounted Payback Period=	3.88	YEARS	(3+(804446/914519)
		NET PRESENT VALUE(NPV)	$110,073	(SUM of PV of Cash Flows)
		Yes,the project should be accepted
		It meets the minimum return becausev NPV is positive
		InternalRate of Return (IRR	16.5%	(Using IRR function of excelover the net cash flow)
		Yes,the project should be accepted
		IRR is more than 15%
		Profitability Index =(NPV+ initial cash flow)/Initialcash flow
		Profitability index=	1.04	((110073+2700000+121739)/(2700000+121739)
		Yes,the project should be accepted
		Profitability index is more than 1