Question

Revenues generated by a new fad product are forecast as follows:

Year Revenues

1 45000

2 35000

3 25000

4 20000

Expenses are expected to be 40% of revenues, and working capital required in each year is expected to be 20% of revenues in the following year. The product requires an immediate investment of $60,000 in plant and equipment.

c. If the opportunity cost of capital is 12%, what is the project's NPV?

d. What is project IRR?

Answer 1

Steps to solve:

1. We find all the component of cashflow eahc year. i.e Initial Investment , Operating Cash profit and Working capital

2. Required Working Capital required shall be 20% of next year sales. Changes in working capital shall be difference of opening and required. As the sales is reducing year on year, working capital required shall also reduce and each year some portion of working capital will be free.

3. Operating Profit = Revenue - 40% revenue (Expenses)

4. We discount the cashflows using discount factor which is 1/(1+R)^N for eg for year 1 = 1/(1+12%)^1 =   0.8928

5. We find the present value and sum it up.

Particulars	0	1	2	3	4
Initial Investment (a)	-60000
Working Capital
Opening	0	9000	7000	5000	4000
Required	-9000	-7000	-5000	-4000	0
Change in Working Capital (b)	-9000	2000	2000	1000	4000
Revenue		45000	35000	25000	20000
Less Expenses		-18000	-14000	-10000	-8000
Operating Profit / Cash Profit ©		27000	21000	15000	12000
Net Cashflow (a+b+c)	-69000	29000	23000	16000	16000
Discount Rate	12%
Discount Factor	1	0.892857	0.797194	0.71178	0.635518
Present Value	-69000	25892.86	18335.46	11388.48	10168.29
Total Present Value	-3214.91045

As NPV is negative we dont select the project.

2. Now we need to find the IRR. IRR shall be the rate at which NPV is nil.

By using various permutations, we find that 9.49%, NPV is NIL.

We used the goal seek function such that goal was to have NPV as Nil and variable being the discount factor.

Particulars	0	1	2	3	4
Initial Investment (a)	-60000
Working Capital
Opening	0	9000	7000	5000	4000
Required	-9000	-7000	-5000	-4000	0
Change in Working Capital (b)	-9000	2000	2000	1000	4000
Revenue		45000	35000	25000	20000
Less Expenses		-18000	-14000	-10000	-8000
Operating Profit / Cash Profit ©		27000	21000	15000	12000
Net Cashflow (a+b+c)	-69000	29000	23000	16000	16000
Discount Rate	9.49%
Discount Factor	1	0.913355	0.834218	0.761937	0.695919
Present Value	-69000	26487.3	19187.01	12190.99	11134.7
Total Present Value	0.00