Question

1. Five Stars Inc., is considering a new three-year expansion project that requires an initial fixed asset investment of 3.9 million. The fixed asset will be depreciated straight-line to zero over its three-year tax life, after which time it will be worthless. The project is estimated to generate $2,650,000 in annual sales, with costs of $840,000. Suppose the project requires an initial investment in net working capital of $300,000 and the net working capital will be fully recovered at the end of the project. If the tax rate is 21% and the required rate of return on the project is 12%, what is the project’s NPV?

2. Summer Tyme, Inc., is considering a new three-year expansion project that requires an initial fixed asset investment of $3.9 million. The fixed asset falls into the three-year MARCRS class and will be depreciated over its three-year tax life. The project is estimated to generate $2,650,000 in annual sales, with costs of $840,000. Suppose the project requires an initial investment in net working capital of $300,000 and the net working capital will be fully recovered at the end of the project. Also, the fixed asset will have a market value of $210,000 at the end of the project. Suppose that the tax rate is 21% and the required rate of return on the project is 12%. What are the project’s NPV and IRR? Should the firm accept this project?

3. Dog Up! Franks is looking at a new sausage system with an installed cost of $560,000. This cost will be depreciated straight-line to zero over the project’s five-year life, at the end of which the sausage system can be sold for $85,000 in the market. The sausage system will save the firm $165,000 per year in pretax operating costs, and the system requires an initial investment in net working capital of $29,000. If the tax rate is 21% and the required rate of return of the project is 10%, what is the NPV of this project?

Answer 1

1. Five Star Inc.

NPV = PV of Net Inflow - Initial Outflow + PV of Returned Capital

PV of Net Inflow

Year	Sales	Costs	Depreciation	Profit before tax	Net Income (Profit After tax)	Net Inflow	DCF @ 12%	PV Net Income
1	26,50,000	8,40,000	13,00,000	5,10,000	4,02,900	17,02,900	0.89	15,20,689.70
2	26,50,000	8,40,000	13,00,000	5,10,000	4,02,900	17,02,900	0.80	13,57,211.30
3	26,50,000	8,40,000	13,00,000	5,10,000	4,02,900	17,02,900	0.71	12,12,464.80
Total								40,90,365.80

Initial Outflow = $ 3,900,000 + $ 300,000 = $ 4,200,000

PV of Returned Capital = $300,000*0.71

= $213,600

NPV = $ 40,90,365.80 - $ 4,200,000 + $213,600

= $ 103,965.8

2. Summer Tyme Inc.

NPV = PV of Net Inflow - Initial Outflow + PV of Returned Capital + PV of Salvage Value

PV of Net Inflow

Year	Sales	Costs	Depreciation	Profit before tax	Net Income (Profit After tax)	Net Inflow	DCF @ 12%	PV Net Income
1	26,50,000	8,40,000	13,00,000	5,10,000	4,02,900	17,02,900	0.89	15,20,689.70
2	26,50,000	8,40,000	13,00,000	5,10,000	4,02,900	17,02,900	0.80	13,57,211.30
3	26,50,000	8,40,000	13,00,000	5,10,000	4,02,900	17,02,900	0.71	12,12,464.80
Total								40,90,365.80

Initial Outflow = $ 3,900,000 + $ 300,000 = $ 4,200,000

PV of Returned Capital = $300,000*0.71

= $213,600

PV of Salvage Value = $ 210,000*0.71

= $ 149,520

NPV = $ 40,90,365.80 - $ 4,200,000 + $213,600 + $ 149,520

= $ 253,485.8

Calculation of IRR

Year	Initial Overlay	Net Inflow	Salvage and WC	Net Cash Flow
0	42,00,000	-	-	(42,00,000)
1	-	17,02,900	-	17,02,900
2	-	17,02,900	-	17,02,900
3	-	17,02,900	5,10,000	22,12,900
	IRR			15.32%

Comapany is earning a postive NPV and have an internal rate of return greater than the cost of capital (required rate of return). Hence, the company should opt for the project.

3.Dog Up ! Franks

NPV = PV of Net Inflow - Initial Outflow + PV of Returned Capital + PV of Salvage Value

PV of Net Inflow

Year	Savings in Operating Costs	Depreciation	Profit before tax	Net Income (Profit After tax)	Net Inflow	DCF @ 10%	PV Net Income
1	1,65,000	1,12,000	53,000	41,870	1,53,870	0.91	1,39,881.82
2	1,65,000	1,12,000	53,000	41,870	1,53,870	0.83	1,27,165.29
3	1,65,000	1,12,000	53,000	41,870	1,53,870	0.75	1,15,604.81
4	1,65,000	1,12,000	53,000	41,870	1,53,870	0.68	1,05,095.28
5	1,65,000	1,12,000	53,000	41,870	1,53,870	0.62	95,541.16
Total							583,288.36

Initial Outflow = $ 560,000 + $ 29,000 = $ 589,000

PV of Returned Capital = $29,000*0.62

= $18,006.72

PV of Salvage Value = $ 85,000*0.62

= $ 52,778.31

NPV = $ 583,288.36 - $ 589,000 + $18,006.72 + $ 52,778.31

= $ 65,073.39