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In: Finance
Dr. Chan is considering a four year project. The project requires an initial investment of $10,000,000...
Dr. Chan is considering a four year project. The project requires an initial investment of $10,000,000 to buy new equipment. The equipment will be depreciated straight line to zero over the project’s life. The company believes it can generate $5,000,000 in pretax revenues in year 1. Revenues will increase at 20% per year. Total pretax operating cost would be 40% of the pretax revenues. Net working capital will be 20% of the pretax revenue for the year. Net working capital will be fully recovered at the end of the project. Revenues and operating costs will occur at the end of the year and investment in net working capital will be made at the beginning of the year. The tax rate is 40% and the discount rate is 12%.
a.What is the NPV of the project?
b.Now compute the project’s NPV assuming the project is abandoned after one year. The equipment will be salvaged for $8,000,000. Any gain or loss due to selling the equipment for other than the book value will create taxable gain/loss.
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Expert Solution
| Year | 0 | 1 | 2 | 3 | 4 |
| 1. Initial investment | -10000000 | ||||
| 2.NWC reqd. | 1000000 | 1200000 | 1440000 | 1728000 | 0 |
| 3.Change in NWC | -1000000 | -200000 | -240000 | -288000 | 1728000 |
| 4.Pretax revenues | 5000000 | 6000000 | 7200000 | 8640000 | |
| 5.Pretax costs | -2000000 | -2400000 | -2880000 | -3456000 | |
| 6.Depn.(10000000/4) | -2500000 | -2500000 | -2500000 | -2500000 | |
| 7.EBIT (sum 4 to 6) | 500000 | 1100000 | 1820000 | 2684000 | |
| 8.Tax at 40%(7*40%) | -200000 | -440000 | -728000 | -1073600 | |
| 9.NOPAT(7+8) | 300000 | 660000 | 1092000 | 1610400 | |
| 10.Add Back :depn.(row 6) | 2500000 | 2500000 | 2500000 | 2500000 | |
| 11.Opg. Cash flow(9+10) | 2800000 | 3160000 | 3592000 | 4110400 | |
| 12. Annual FCFs(1+3+11) | -11000000 | 2600000 | 2920000 | 3304000 | 5838400 |
| 13. PV F at 12%(1/1.12^yr.n) | 1 | 0.89286 | 0.79719 | 0.71178 | 0.63552 |
| 14. PV at 12%(12*13) | -11000000 | 2321429 | 2327806 | 2351722 | 3710409 |
| 15. NPV at 12%(sum of row 14) | -288634.62 | ||||
| (ANSWER) |
| Project abandoned after 1 year | ||
| Year | 0 | 1 |
| 1. Initial investment | -10000000 | |
| 2.NWC reqd. | 1000000 | 0 |
| 3.Change in NWC | -1000000 | 1000000 |
| a.ATCF on salvage | 7800000 | |
| 4.Pretax revenues | 5000000 | |
| 5.Pretax costs | -2000000 | |
| 6.Depn.(10000000/4) | -2500000 | |
| 7.EBIT (sum 4 to 6) | 500000 | |
| 8.Tax at 40%(7*40%) | -200000 | |
| 9.NOPAT(7+8) | 300000 | |
| 10.Add Back :depn.(row 6) | 2500000 | |
| 11.Opg. Cash flow(9+10) | 2800000 | |
| 12. Annual FCFs(1+3+a+11) | -11000000 | 11600000 |
| 13. PV F at 12%(1/1.12^yr.n) | 1 | 0.89286 |
| 14. PV at 12%(12*13) | -11000000 | 10357143 |
| 15. NPV at 12%(sum of row 14) | -642857.14 | |
| (ANSWER) | ||
| Workings: | ||
| Cost | 10000000 | |
| Less:Acc. Depn. | 2500000 | |
| Carrying value | 7500000 | |
| Salvage | 8000000 | |
| Gain on salvage | 500000 | |
| Tax on gain (500000*40%) | 200000 | |
| ATCF on sale (8000000-200000) | 7800000 |
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