Question

3. CLC is considering a new project. Planning horizon is 3 years and the cost of capital is 11%. They expect sales of $20,000,000 next year with sales to grow by 25% for the next 2 years. Variable costs (COGS or Cost of Goods Sold) are 60% of sales. This does not include depreciation expense. They require a machine that costs $12,000,000. It will be depreciated on a straight-line basis over 3 years to a zero book value. The tax rate is 30%.

a. Find the internal rate of return on the project. Should they take it? Explain.

b. Add the following information to your analysis and recalculate the internal rate of return:

• They can sell the machine for $3M at the end of year 3.

• Initial net operating working capital is $1,500,000. Net operating working capital in years 1, 2 and 3 is 10% of same year sales. There is no return of net operating working capital.

Answer 1

Case -1
	Particulars	Year 0	Year 1	Year 2	Year 3
	sales		20000000	25000000	31250000
	Cost of Goods sold		12000000	15000000	18750000
	Depreciation		4000000	4000000	4000000
	Net Profit		4000000	6000000	8500000
	Tax @30%		1200000	1800000	2550000
	profit after tax		2800000	4200000	5950000
	Cash Flow	-12000000	6800000	8200000	9950000
	IRR	44%
Case -2
	Particulars	Year 0	Year 1	Year 2	Year 3
	sales		20000000	25000000	31250000
	Cost of Goods sold		12000000	15000000	18750000
	Depreciation		3000000	3000000	3000000
	Net Profit		5000000	7000000	9500000
	Tax @30%		1500000	2100000	2850000
	profit after tax		3500000	4900000	6650000
	Cash flow on sale of machine				3000000
	Cash Flow	-12000000	6500000	7900000	12650000
	Working capital requirement	-1500000	-500000	-500000	-625000
	Net Cash flow	-13500000	6000000	7400000	12025000
	IRR	34%
Notes
	Impact on tax on depreciation has not been provided.
	As given in question no return on net working capital hence terminal cash of operating working capital not considered
	Increase in working capital has only been considered in year 1,2 and 3.