Question

What is the net present value of the stadium project, which is a 3-year project where Fairfax Pizza would sell pizza in the baseball stadium? The project would involve an initial investment in equipment of 160,000 dollars today. To finance the project, Fairfax Pizza would borrow 160,000 dollars. The firm would receive 160,000 dollars from the bank today and would pay the bank 206,400 dollars in 3 years (consisting of an interest payment of 46,400 dollars and a principal payment of 160,000 dollars). Cash flows from capital spending would be 0 dollars in year 1, 0 dollars in year 2, and 10,000 dollars in year 3. Operating cash flows are expected to be 92,800 dollars in year 1, 91,200 dollars in year 2, and -51,200 dollars in year 3. The cash flow effects from the change in net working capital are expected to be -10,000 dollars at time 0; -9,000 dollars in year 1; 10,000 dollars in year 2; and 9,000 dollars in year 3. The tax rate is 10 percent. The cost of capital is 17.46 percent and the interest rate on the loan would be 8.86 percent.

Answer 1

Answer -

Following are some assumptions made while solving the question:

1. Depreciation is taken on the equipment cost of $160,000 at straight-line method for 3 years at the end of each year, since no depreciation rates are given.
2. Depreciation is taken to ascertain the tax saving on the depreciation amount.
3. Salvage value of the equipment is considered to be $10,000 that is the cash flows from capital spending at the end of year 3.
4. It is assumed that Fairfax Pizza would pay interest and principal at the end of year 3 at the rate of 8.86% on cumulative balance each year. Hence, Interest = $160,000 (1 + 0.0886)3 - $160,000 = $46,400.
5. Cost of capital of 17.46% shall be considered as discount rate for future cash flows.

Alternate answer may possible if assumptions made differs.

Statement showing cash flows

Amount ($)

Particulars	Working	Year 1	Year 2	Year 3
Operating cash flows	Given	92800	91200	-51200
Interest	[$160,000 (1 + 0.0886)3 - $160,000]	0	0	-46400
Depreciation	[($160,000 - $10,000) / 3]	-50000	-50000	-50000
Profit before tax		42800	41200	-147600
Tax	10% of Profit before tax	-4280	-4120	14760
Profit after tax		38520	37080	-132840
Depreciation	Add back	50000	50000	50000
Cash Flow		88520	87080	-82840

Statement showing Net Present Value of the stadium project

Amount ($)

Year	Particulars	Notes / Working	Amount (A)	Discount Factor @ 17.46% (B)	Present Value (A * B)
0	Working capital	Given	-10,000	1	-10,000
1	Cash Flow	Calculated above	88520	0.8514	75362
1	Working capital	Given	-9,000	0.8514	-7662
2	Cash Flow	Calculated above	87,080	0.7248	63116
2	Working capital	Given	10,000	0.7248	7248
3	Cash Flow	Calculated above	-82,840	0.6171	-51118
3	Working capital	Given	9,000	0.6171	5554
3	Salvage value of equipment	Given	10,000	0.6171	6171
3	Principal payment of equipment loan	Outflow at the end of year 3	-160,000	0.6171	-98730
	Net Present Value	-10060