Question

Kemmerer Pen, a manufacturer of stationary, is considering a new investment that
requires the use of an existing warehouse, which the firm acquired four years ago for $2
million but is currently redundant (unused).
• The warehouse’s market rental price is $200,000 (pre-tax) per year at year zero.
• Rental price for the warehouse will increase at a growth rate of 5% from year 1 to
year 5.
• In addition to using the warehouse, the project requires an up-front investment into
machines and other equipment of $6 million. This investment can be fully
depreciated straight-line over the next six years for tax purposes with a salvage
value of 0.
• However, the company expects to terminate the project at the end of five years and
to sell the machines and equipment for $1.5 million.
• The project requires an initial investment (incur at Year 0) into net working capital
equal to 5% of predicted first-year sales. Subsequently, net working capital is 5%
of the predicted sales over the following year but will be fully recovered at the
end of year 5.
• Sales of pens are expected to be $5 million in the first year and to stay stable for
five years. Total manufacturing costs and operating expenses (excluding
depreciation) are 60% of sales. And profits are taxed at 30%.

a) What are the free cash flows of the project from Year 0 to Year 5 respectively? (6
marks). If the cost of capital is 10%, what is the NPV of the project?

b) If a borrowing interest payment of $600,000 for this project is made per year
during the investing period, will it change Kemmerer Pen’s investment decision?

Answer 1

Free cashflow of the project:

Sl.No	Year	0	1	2	3	4	5
i	Sales of pens (given)		5,000,000	5,000,000	5,000,000	5,000,000	5,000,000
ii	Capital gain (W.no.1)						500,000
iii	Operating costs (given)		(3,000,000)	(3,000,000)	(3,000,000)	(3,000,000)	(3,000,000)
iv	EBITDA (i+ii+iii)		2,000,000	2,000,000	2,000,000	2,000,000	2,500,000
v	Depreciation (6million/6years)		(1,000,000)	(1,000,000)	(1,000,000)	(1,000,000)	(1,000,000)
vi	EBIT (iv+v)		1,000,000	1,000,000	1,000,000	1,000,000	1,500,000
vii	Tax @ 30% (vi*0.3)		(300,000)	(300,000)	(300,000)	(300,000)	(450,000)
viii	Profit after tax (vi-vii)		700,000	700,000	700,000	700,000	1,050,000
ix	Add: Depreciation (v)		1,000,000	1,000,000	1,000,000	1,000,000	1,000,000
x	Less: Capital gain (W.no.1)						500,000
xi	Less: Opportunity cost after tax (W.no.2)		147,000	154,350	162,068	170,171	178,679
xii	Less: Investment in equipments (given)	6,000,000
xiii	Add: sale of equipments (given)						1,500,000
xiv	Less: Net working capital (given)	250,000
xv	Add: Net working capital recovered (given)						250,000
xvi	Free cashflows (viii+ix-x-xi-xii+xiii-xiv+xv)	(6,250,000)	1,553,000	1,545,650	1,537,933	1,529,829	3,121,321
xvii	Present value factor @ 10%	1	1/1.1 = 0.9091	0.9091/1.1 = 0.8265	0.8265/1.1 = 0.7514	0.7514/1.1 = 0.6831	0.6831/1.1 = 0.6210
xviii	Discounted cash flows (xvi*xvii)	(6,250,000)	1,411,832	1,277,480	1,155,602	1,045,026	1,938,340

Free cash flows = refer Sl.no xvi

NPV = sum of discounted cash flows = -6,250,000+ 1,411,832+1,277,480+1,155,602+1,045,026+1,938,340 = $578,280

W.no.1) Capital gain

Book value of equipment at the end of 5th year = cost - depreciation upto year 5 = $6million-$5million = $1million

Capital gain = Sale value - Book value of equipment at the end of 5th year = $1.5million-$1million =$500,000

It is taxable at the year of sale.

W.no.2) Opportunity cost

Rental recepit (Pre-tax) for year 1 = $200,000*(1+growth rate) = $200,000*1.05 = $210,000

Rental recepit after tax for year 1 = Rental recepit (Pre-tax) for year 1*(1-tax rate) = $210,000*(1-0.3) = $210,000*0.7 = $147,000

Rental recepit after tax for year 2 = Rental recepit after tax for year 1*(1+growth rate) = $147,000*(1+0.05) = $147,000*1.05 = $154,350

Rental recepit after tax for year 3 = Rental recepit after tax for year 2*(1+growth rate) = $154,350*(1+0.05) = $154,350*1.05 = $162,068

Rental recepit after tax for year 4 = Rental recepit after tax for year 3*(1+growth rate) = $162,068*(1+0.05) = $162,068*1.05 = $170,171

Rental recepit after tax for year 5 = Rental recepit after tax for year 4*(1+growth rate) = $170,171*(1+0.05) = $170,171*1.05 = $178,679

Part b) Yes, it will change Kemmerer pen's investment decision because it gives negative NPV from the project.

Interest payment = $600,000 each year

Net outflow = Interest payment-tax shield = $600,000*($600,000*0.3) = $600,000-$180,000 = $420,000

Present value of net interest outflow = Net outflow*PVF @ 10% = ($420,000*0.9091)+($420,000*0.8265)+($420,000*0.7514)+($420,000*0.6831)+($420,000*0.621) = $420,000*(0.9091+0.8265+0.7514+0.6831+0.6210) = $420,000*3.7911 = $1,592,262

NPV = NPV in part a - Present value of net interest outflow = $578,280-$1,592,262 = -$1,013,982