Question

frigi co. has recently completed a $400,000 two-year marketing study. based on the results, frigi has estimated that 10,000 of its new cold rooms could be sold annually over the next five years at a price of $9,615 each. subcontractors would install the cold rooms at a constant price per installation of $7,400. fixed costs to be incurred would be $12 million per year.start-up costs include $40 million to build production facilities and $2.4 million in land. the $40 million facility will be depreciated for tax purposes at prime cost (i.e. straight-line) to zero over the project’s life. at the end of the project’s life, the facilities (including the land) will be sold for an estimated $8.4 million. the value of the land is not expected to change.finally, start-up would also entail fully deductible expenses of $1.4 million at year zero. frigi is an ongoing, profitable business and pays company tax at the 30 per cent rate in the year of income on all income and gains. frigid uses a 10 per cent discount rate on projects such as this one.

a) identify the relevant cash flows for frigi’s proposal –at the start, over the life and at the end.

b) calculate the npv for this proposal.

c) should frigi co. proceed with this proposal? why

*Note: This is the full question I have got no more addition information.

Answer 1

a]
1]	INITIAL INVESTMENT:
	Cost of land	$           24,00,000
	+Cost of production facilities	$ 4,00,00,000
	+After tax start up expenses = 1400000*(1-30%) =	$             9,80,000
	=Initial investment	$ 4,33,80,000
2]	ANNUAL OPERATING CASH FLOWS:
	Sales [10000*9615]	$ 9,61,50,000
	-Payment to subcontractors [10000*7400]	$ 7,40,00,000
	-Fixed costs	$ 1,20,00,000
	-Depreciation = 40000000/5 =	$           80,00,000
	=NOI	$           21,50,000
	-Tax at 30%	$             6,45,000
	=NOPAT	$           15,05,000
	+Depreciation	$           80,00,000
	=OCF	$           95,05,000
3]	TERMINAL NON OPERATING CASH FLOWS:
	Sale value of production facilities and land	$           84,00,000
	Book value of land and production facilities [2400000+0]	$           24,00,000
	Gain on sale	$           60,00,000
	Tax at 30% on gain	$           18,00,000
	After tax sale proceeds = 8400000-1800000 =	$           66,00,000
b]	CALCULATION OF NPV:
	PV of annual OCF = 9505000*(1.1^5-1)/(0.1*1.1^5) =	$       3,60,31,428
	+PV of terminal cash inflows = 6600000/1.10^5 =	$ 40,98,081
	=PV of cash inflows	$       4,01,29,509
	-Initial investment	$       4,33,80,000
	=NPV	$         -32,50,491
c]	Frigi should not proceed with the proposal as the NPV
	is negative. It will result in erosion of shareholders' wealth
	to the extent of -$3,250,491