Question

A proposal to build a $187 million factory is being contemplated to produce a new product. The factory is expected to last 20 years (but can be depreciated immediately according to current accounting rules). The factory is expected to produce 8000 units per year that are expected to be sold for a price of $26,000 each. Variable costs (production labor, raw materials, marketing, distribtuion, etc.) are expected to be $17,000 per unit. Fixed costs (administration, maintenance, repairs, utliities, insurance, real estate taxes, etc.) are expected to be $16 million per year. The tax rate is 21%. The project will require $24 million in inventory (raw materials and finished products) as well as $42 million in receivables (credit for customers). An extra $11 million in cash is required as a safety stock to provide financial flexibility (that enables avoiding running out of cash in case of temporary declines in demand). Suppliers (companies which sell the parts and raw materials that are used in the production of the 8000 units produced by the factory) are expected to provide short-term trade credit that is expected to sum to $17 million in accounts payable

COST OF EQUITY= 4.668%

1. Compute equivalent annual cash flow (EAC) and compare that to another project with an annual EAC of $12 million that can alternatively be selected (and re-evaluate the project in this context)

Answer 1

Computation of EAC

----OutFlow in Year 0 =  $187 mn

----Inflow from Year 1-20

Revenue = 8000 Units p.a * 26000 = $208 mn

Variable cost = 8000 Units p.a * 17000 = $136 mn

Fixed Cost = $16mn

Profit Before Tax = $56 mn (208-136-16)

Less Tax @21% = $11.76 mn

Profit after Tax = $44.24 mn

-----Change in Working Capital in Year 1 and Year 20(There will be no change in WC in other years as same Working Capital is expected to be maintained in Further Years)

[ Opening - Closing ] =

Year 1 =[ 0 - (24 mn + 42 mn + 11mn - 17mn] = $60 mn Outflow

Year 20 =[(24mn + 42 mn + 11mn - 17mn) - 0] = $60 mn Inflow

-----

Step1 - NPV Computation

Year PVF/[email protected]% Cash Flow Present Value

0 1 -187 mn -187 mn   

1 0.96 -60 mn -57.6 mn

1-20 12.82 +44.24 mn +567.26 mn

20 0.40 +60 mn +24 mn

Net Present Value (NPV) =+346.66 mn

Step 2 - EAC (Equivalent Annual Cash Flow)

=NPV / Annuity Factor = 346.66mn / 12.82 = $27 mn (Appraox.)

Comparing with Alternate Project

This Project's EAC = $27mn Inflow

Alternate Project's EAC = $12mn Inflow

  This project is better as it has more EAC than its alternate Project.