High Flyer, Inc., is considering an investment in a new distribution center. High Flyer’s CFO anticipated...

High Flyer, Inc., is considering an investment in a new distribution center. High Flyer’s CFO anticipated additional earnings before interest and taxes of $100,000 for the first year of operation of the center, and, over the next five years, the firm estimates that this amount will grow at a rate of 5% per year. The distribution center will require an initial investment of $600,000 that will be depreciated over a five-year period toward a zero salvage value using straight-line depreciation. It is estimated that the distribution center will need operating net working capital equal to 25% of EBIT to support operation. At the end of the 5th year, High Flyer will sell the distribution center for an estimated amount of $10,000. High Flyer’s WACC is 19% and it faces a 30% tax rate. Part a What is the value of this project? Part b Should the company undertake this project? Part c Under what condition will you change your recommendation?

Expert Solution

Net value calculation of the project:

Year (n)	Initial Investments	Depreciation (D)	Salvage value	Earnings before interest and taxes (EBIT)	Net Working Capital (NWC) (25% of EBIT)	Before taxes cash flow (BTCF) (EBIT-NWC + Salvage value)	Taxable Income (BTCF - depreciation)	Income taxes (Taxable Income *30%)	After Tax Net Income (taxable income - taxes)	Free Cash Flow = ( Net Income + depreciation)	PV of after tax cash flow @19% = FCF/ (1+19%)^t
0	-$600,000									-$600,000	-$600,000
1		$120,000		$100,000	$25,000	$75,000	-$45,000	-$13,500	-$31,500	$88,500	$74,370
2		$120,000		$105,000	$26,250	$78,750	-$41,250	-$12,375	-$28,875	$91,125	$64,349
3		$120,000		$110,250	$27,563	$82,688	-$37,313	-$11,194	-$26,119	$93,881	$55,711
4		$120,000		$115,763	$28,941	$86,822	-$33,178	-$9,953	-$23,225	$96,775	$48,259
5		$120,000	$10,000	$121,551	$30,388	$101,163	-$18,837	-$5,651	-$13,186	$106,814	$44,760
Value of the project											-$312,551


Note:
1. Salvage value of fixed asset at the end of year 5 is taken as income and fully taxed.
2. For Negative Taxable Income, a tax credit is assumed

a. What is the value of this project?

The value of this project -$312,551

b. Should the company undertake this project?

The company should not undertake this project as the value of this project is negative.

c. Under what condition will you change your recommendation?

If the value of the project become positive at current discount rate (WACC =19%) then company can undertake this project.

keosha answered 1 year ago

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