Question

In: Finance

I would like some explanation on where values come from and not just a spread sheet...

I would like some explanation on where values come from and not just a spread sheet with answers like the rest of the similar problems). i am trying to create this in excel for future use. Thank you.

Arnold Inc. is considering a proposal to manufacture​ high-end protein bars used as food supplements by body builders. The project requires use of an existing​ warehouse, which the firm acquired three years ago for $2 million and which it currently rents out for $112,000 Rental rates are not expected to change going forward. In addition to using the​ warehouse, the project requires an upfront investment into machines and other equipment of $1.5 million. This investment can be fully depreciated​ straight-line over the next 10 years for tax purposes. ​ However, Arnold Inc. expects to terminate the project at the end of eight years and to sell the machines and equipment for $598,000. Finally, the project requires an initial investment into net working capital equal to 10 percent of predicted​ first-year sales.​ Subsequently, net working capital is 10 percent of the predicted sales over the following year. Sales of protein bars are expected to be $4.9 million in the first year and to stay constant for eight years. Total manufacturing costs and operating expenses​ (excluding depreciation) are 80 percent of​ sales, and profits are taxed at 30 percent.

a. What are the free cash flows of the​ project?

b. If the cost of capital is 15 % what is the NPV of the​ project?

Solutions

Expert Solution

First We will Calculate After Tax Cash Flow from Sales of the Machine

Initial Investment = $ 1500,000

Useful Life of the Machine = 10 Years

Depreciation each year = Initial Investment / Years = 1500,000 / 10 = 150,000

Book Value of the Machine after 08 Years = Initial Investment - Years *  Depreciation each year

=  1500,000 - 8* 150,000 = 300,000.

Sales Value of the Machine after 08 Years = $598,000

Since Sales Value Higher than Book Value, there will be a tax on Sales

Taxable Value = Sales Value -- Book Value = $598,000 - $ 300,000 = $ 298,000

Tax = Taxable Value * Tax Rate = $ 298,000 * 30% = 89,400

After-Tax Cash flow from Sale of the Machine = Sales Value - Tax = $598,000 - $ 89,400 = $ 508,600

Cash Flow

Fixed Cost each Year =  $112,000 ( Loss in Rental each Year)

Sales Each Year = $4.9 million = $ 4900,000

manufacturing costs and operating expense each year = 80% of Sales = 80% * $ 4900,000 = 3920,000

Investment in Working Capital

In Initial Year ( Year 0) = 10% of First-Year Sales = 10% *  4900,000 = 490,000

Subsequent Investment in Working Capital = 10% of Projected Next Years Sales = 10% *4900,000 = 490,000

[ Keep in Mind this will continue to Year 07 : In Year 08 is the last Year Project ]

Cash Inflow from Working Capital at end of the Projected = Total Investment in Working Capital = 490,000 * ( No of Years Investment) =  490,000 * 08 = 3920,000

[ 08 Due to considering Year 0 to Till Year 07 ]

free cash flows calculation :

Free Cash flow in Each Year = EBIT - Tax Payment + Depreciation

[ We add back depreciation in Operating Cash flow as it is a non-cash expense. First, we need to subtract depreciation for calculating EBIT and Tax Payment ]

Present Value of Free Flow

Discounting free cash flows =  Free Cash flow / ( 1+ r)^Year [ r = 10% ]

NPV

Sum of Present Value of Free Flow = 6,74,683 (Ans)

Ans : Free Cash Flows for the Project : (Ans)

Year : 0 1 2 3 4 5 6 7 8
-1890000 3,09,600 3,09,600 3,09,600 3,09,600 3,09,600 3,09,600 3,09,600 39,05,200


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