In: Finance
You are financial managers of a company which makes printers. Currently you are using NPV method to evaluate a 10-year project that produces a new model.
The WACC is 10% and the tax rate is 21%. (2 points)
Question 1: How much is the initial investment at t=0?
Question 2: How much is the operating cash flow for the first year?
Question 3: How much is the non-operating cash flow at the end of the last year?
Question 4: How much is the NPV?
1. Initial Investment at t=0
a. Cost of the machine = $5,000,000
b. Working capital requirements = Increase in Inventory + Increase in receivables - Increase in payables + Increase in minimum cash = $1,500,000+$1,000,000-$800,000+$500,000 = $2,200,000 (this is a net working capital investment resulting in cash-outflow)
Total Initial Investment at t=0 = $5,000,000 +$2,200,000= $7,200,000
R&D spend of $800,000 which is already incurred is a sunk cost and not relevant in the decision making.
2. Operating Cash flow:
a. Total Sales per year = $8,000,000.
% being lost sales of existing products = 20%
Thus, net sales per year = $8,000,000*(100%-20%) = $6,400,000 per annum
b. Variable cost = 30% of sales = 30% * $6,400,000 = $1,920,000 per annum
c. Cost of new manager hired = $100,000 per annum
d. Rental of new office = $50,000 per annum
e. Overhead of the firm = $500,000 per annum
Allocation to the project = 20%
Overhead of the project = $500,000*20% = $100,000 per annum
f. Interest on debt = $100,000 per annum
g. Depreciation on straight line basis for 10 years
Cost of the machine = $5,000,000
Depreciation per annum = $5,000,000/10 = $500,000
h. Profit Before Tax = Net Sales - Variable cost - Cost of new manager hired - Rental of new office - Overhead of the project - Interest on debt - Depreciation = $6,400,000 - $1,920,000-$100,000-$50,000-$100,000-$100,000-$500,000 = $3,630,000
i. Tax rate = 21%
Thus, tax = Profit Before Tax * tax rate = $3,630,000*21% = $762,300
j. Profit After Tax = Profit Before Tax - Tax = $3,630,000 - $762,300 = $2,867,700
k. Operating cash flow = Profit after tax + Depreciation = $2,867,700+$500,000 = $3,367,700 (for years 1 to 10)
3. Non operating cash-flow at the end of the last year
Net working capital investment at year 0 = $2,200,000
Recovery of net working capital at year 10 = $2,200,000 (recovery is a cash-inflow).
Though the question is silent on working capital recovery, generally working capital gets recovered at the end of the project and hence this is a fair assumption to make when the question is silent.
4. Net Present Value =
a. Discount factor at 10% =
Year 1 = 1/(100%+10%)^1 = 0.909
Year 2 = 1/(100%+10%)^2 = 0.826
Year 3 = 1/(100%+10%)^3 = 0.751
Year 4 = 1/(100%+10%)^4 = 0.683
Year 5 = 1/(100%+10%)^5 = 0.621
Year 6 = 1/(100%+10%)^6 = 0.564
Year 7 = 1/(100%+10%)^7 = 0.513
Year 8 = 1/(100%+10%)^8 = 0.467
Year 9 = 1/(100%+10%)^9 = 0.424
Year 10 = 1/(100%+10%)^10 = 0.386
Total of discount factor of 10 years = (sum of 10 years rates) = 6.145 (cumulative discount factor for 10 years)
b. Net Present Value = - Initial Investment at year 0 + (Operating cash flow per year * 10 years * cumulative discount factor for 10 years) + (Net working capital recovery at year 10 * discount factor of year 10)
=-$7,200,000 +($3,367,700*10*6.145)+($2,200,000*0.386) = -$7,200,000+$20,693,059+$848,195 = $14,341,254
Thus, NPV of the project = $14,341,254
Since the NPV is positive, the project can be undertaken.