Question

Revenues generated by a new fad product are forecast as follows:

Year	Revenues
1	$40,000
2	20,000
3	15,000
4	10,000
Thereafter	0

Expenses are expected to be 40% of revenues, and working capital required in each year is expected to be 20% of revenues in the following year. The product requires an immediate investment of $46,000 in plant and equipment.

Required:

a. What is the initial investment in the product? Remember working capital.

b. If the plant and equipment are depreciated over 4 years to a salvage value of zero using straight-line depreciation, and the firm’s tax rate is 20%, what are the project cash flows in each year? Assume the plant and equipment are worthless at the end of 4 years.

c. If the opportunity cost of capital is 10%, what is the project's NPV?

d. What is project IRR?

Answer 1

a.Intial investment in the project = $ 46,000 + $ 40,000 x 0.20 = $ 54,000

b. Annual depreciation expense = $ ( 46,000 - 0 ) / 4 = $ 11,500.

Year	1	2	3	4
Revenues	$ 40,000	$ 20,000	$ 15,000	$ 10,000
Less: Expenses	16,000	8,000	6,000	4,000
EBITDA	24,000	12,000	9,000	6,000
Depreciation	11,500	11,500	11,500	11,500
Operating cash flows after taxes	$ 21,500	$ 11,900	$ 9,500	$ 7,100

Operating cash flows after taxes = EBITDA x ( 1 - t ) + Depreciation x t.

c. NPV : $ ( 8,641)

Year	0	1	2	3	4
Cost of Plant	$ (46,000)
Operating cash flows		$ 21,500	$ 11,900	$ 9,500	$ 7,100
Working capital ( required) recovered	(8,000)	(4,000)	(3,000)	(2,000)	17,000
Project cash flows	$ ( 54,000)	17,500	8,900	7,500	24,100
PV factor at 10 %	1.0000	0.9091	0.8264	0.7513	0.6830
Present Values	(54,000)	15,909.25	7,354.96	5,634.75	16,460.30
Net Present Value	$ 8,640.74)

d. IRR: 3 %