Question

Wing Yin Tsui, CEO of Lian Huang & Wong Bin Dean Hwang Manufacturing Limited 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.

Answer 1

a. NPV : - $ 288,546

	0	1	2	3	4
Cost of equipment	(10,000,000)
Revenues		5,000,000	6,000,000	7,200,000	8,640,000
Costs		2,000,000	2,400,000	2,880,000	3,456,000
EBITDA		3,000,000	3,600,000	4,320,000	5,184,000
Depreciation		2,500,000	2,500,000	2,500,000	2,500,000
Operating cash flows after taxes		2,800,000	3,160,000	3,592,000	4,110,400
Net working capital	(1,000,000)	(200,000)	(240,000)	(288,000)	1,728,000
Total cash flows	(11,000,000)	2,600,000	2,920,000	3,304,000	5,838,400
PV factor at 12 %	1.0000	0.8929	0.7972	0.7118	0.6355
Present values	(11,000,000)	2,321,540	2,327,824	2,351,787	3,710,303
Net Present Value	(288,546)

b. NPV : - $ 642,360

	0	1
Cost of equipment	(10,000,000)
Pretax revenues		5,000,000
Costs		2,000,000
EBITDA		3,000,000
Depreciation		2,500,000
Operating cash flows after taxes		2,800,000
Working capital	(1,000,000)	1,000,000
After tax salvage value		7,800,000
Total cash flows	(11,000,000)	11,600,000
PV factor at 12 %	1.0000	0.8929
Present values	(11,000,000)	10,357,640
NPV	(642,360)

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