Question

Pausini Corporation is considering a new equipment for their factory in Milan. The equipment costs    $500,000 today and it will be depreciated on a straight-line basis over five years. In          addition, the      company’s inventory will increase by $81,000 and accounts payable will rise by $29,000. All other           operating working capital components will stay the same. The change in net working capital will be recovered at the end of third year at which time the company sells the equipment at an     expected market value of $200,000. Mrs. Marrone, the financial manager of the company, has           estimated that the equipment will generate revenues of $1,000,000 in year 1, $1,200,000 in                         year 2, and $1,500,000 in year 3. Mrs. Marrone has also estimated the operating costs, excluding depreciation, to be equal 75 percent of revenue of each year.

The project’s cost of capital is 14.25 percent and the company’s tax rate is 40 percent.

What is the project’s net present value (NPV)? What is the project’s MIRR?

Answer 1

calculation of the Depreciation:-

the machine will be depreciated on a straight-line basis over five years.

Per year Depreciation = $500,000 / 5 = $100,000.

Calculation of Tax On sale of Machinery At the end of the 3 rd year.

book value of machine = Cost of machine - amount of Depreciation per year * No. of Year Used.

Book value of Machine = $500,000 - $ 100,000 * 3 years = $200,000

sale Consideration of machine = $ 200,000 Less- Book value of Machine = ($ 200,000)   Gain on sale of machinery   0

Calculation of Operating Free cash flows:

So, Gain is Zero, but there is no tax on sale of machinery.

Calculation of Operating Free cash flows:

Particulars	Year 1	Year 2	Year 3
Revenue	1,000,000	1,200,000	1,500,000
Less-Operating Cost 75% of Revenue	750000	900000	1125000
Less-Depreciation	100000	100000	100000
PBT	150,000	200,000	275,000
Less- TAX@40%	60000	80000	110000
Profit after Tax	90,000	120,000	165,000
Add - Depreciation	100000	100000	100000
Free Operating Cash flows	190,000	220,000	265,000
Add- Sale consideration machine			200,000
Add- Recovery of Working capital			52,000
Total Free cash flows	1,90,000	220,000	517,000

Calculation of Present Value of Cash Out Flows

AT 0 year

cost of Machinery = $ 500,000 Add- Change in Working Capital   = $ 52,000    Initial Investment = 5,52,000

Calculation of Present value of Cash inflows:-

years	Cash flows	PVF @14.25%	Present value
1	190,000	0.8753	166,302
2	220,000	0.7661	168,543
3	517,000	0.6706	346,675
total	681,519

Calculation Of NPV:

NPV = Present value of cash inflows - (present value of cash outflows or initial investment)

NPV = 681,519 - 552,000 = $ 129,519

NPV= $ 129,519    

Calculation of Modified IRR:-

Formula

Modified IRR = ( Terminal Cash flows / Initial cash outlay)1/n - 1

calculation of Terminal cash flows:-

Years	Cash flows	Reinvestment Period(n)	FVF@ 14.25%	Future value
1	190,000	2	1.3053	248008.19
2	220,000	1	1.1425	251350.00
3	517,000	0	1	517000.00
Terminal Cash flows	1,016,358.19

MIRR = ( 1,016,358.19 / 552,000)1/3 -1 = 0.22566

MIRR = 22.57%