Question

Mullum Ltd is considering purchasing new laptop computers. The new laptops have an up-front cost (t=0) of $2,400,000. The laptops are expected to have a four-year life, and will be fully depreciated on a straight-line basis over four years. The company anticipates that after four years, the salvage value will be $200,000. If Mullum goes ahead with the proposed product, it will have an effect on Mullum’s net working capital. At the outset, t = 0, net working capital will increase by $100,000. At t = 4, the net operating working capital will be recovered after the project is completed. The new laptops are expected to generate additional revenue of $1,800,000 every year in the four years (t=1, 2, 3, and 4). Each year the operating costs (not including depreciation) are expected to be 50 percent of sales revenue. To fund the project, Mullum will have to borrow $1,000,000 at 6% annual interest rate from the bank and will pay additional annual interest payment of $600,000 starting from year 1. Cost of capital is estimated to be 12 percent per annum. The corporate tax rate is 40 percent. (a) Calculate the project’s free cash flows in year 0 and show your calculations. (1 mark) (b) Calculate the project’s free cash flows from years 1 to 3 and show your calculations. (c) Calculate the project’s free cash flows from year 4 and show your calculations. (d) What is the Net Present Value (NPV) of this project (round to 2 decimal places)? Is it worthwhile to buy the new laptop computers? Explain your answer.

Answer 1

a]	Cost of the laptops	$ (2,400,000)
	Increase in NWC	$     (100,000)
	FCF in year 0	$ (2,500,000)
b]	Incremental sales revenue	$    1,800,000
	-Incremental operating costs [50% of sales revenue]	$        900,000
	-Depreciation [2400000/4]	$        600,000
	=Incremental NOI	$        300,000
	-Tax at 40%	$        120,000
	=Incremental NOPAT	$        180,000
	+Depreciation	$        600,000
	=FCF [years 1 to 3]	$        780,000
c]	Annual FCF [per (b) above]	$        780,000
	+Recapture of NWC	$        100,000
	+After tax salvage value = 200000*(1-40%)	$        120,000
	FCF in year 4	$    1,000,000
d]	PV of FCF of years 1 to 3 = 780000*(1.12^3-1)/(0.12*1.12^3) =	$    1,873,428
	+PV of FCF of year4 = 1000000/1.12^3 =	$        711,780
	PV of cash inflows	$    2,585,209
	FCF 0	$ (2,500,000)
	NPV	$    5,085,209
	AS THE NPV IS POSITIVE, IT IS WORTHWHILE TO BUY THE
	NEW LAPTOP COMPUTERS.