Question

Kennedy Air is evaluating a new project.  The equipment will cost $50,000 plus $10,000 to install.  It will be depreciated using the MACRS 3-year class.  The project would require an increase in inventories of $6,000 and an increase in A/P of $1,000.  The firm’s yearly revenues would increase by $40,000 but would also increase operating costs by $10,000.  The project is expected to last 3 years and the equipment can then be sold for $10,000.  The firm’s tax rate is 40% and their cost of capital is 12%.  What is the project’s NPV?

Answer 1

NPV of the project is $5,505

Calculations: -

A). Initial cash outflow of the project is $65,000

initial cash outflow = cost of new equipment + increase in Net working

1.cost of new equipment = cost of purchase + installation cost

= $50,000 + $10,000

= $60,000

2.increase in Net working capital

= increase in inventories – increase in accounts payable

= $6,000 - $1,000

= $5,000

initial cash outflow = ($60,000 + $5,000) = $65,000

B.) Yearly operating Cash Flow is $65,486

Step 1: calculation of depreciation

Depreciation base =$60,000

Depreciation expense = depreciation base * rate

years	depreciation rate	depreciation	accumulated depreciation
1	0.333	19980	19980
2	0.445	26700	46680
3	0.148	8880	55560

Step 2: calculation of operating cash flow

Years	$1	$2	$3
Annual Sales	$40,000	$40,000	$40,000
Operating costs	($10,000)	($10,000)	($10,000)
Depreciation expense	($19,980)	($26,700)	($8,880)
EBIT	$10,020	$3,300	$21,120
Tax (40%)	($4,008)	($1,320)	($8,448)
Net income	$6,012	$1,980	$12,672
add non-cash expense(depreciation)	$19,980	$26,700	$8,880
Operating cash flows	$25,992	$28,680	$21,552

C.) Terminal cash flow of the project is $12776

Terminal cash flow = NSV of project assets + Recovered Net working capital

. NSV of new equipment

Book value of new asset (BV)	Depreciation basis - Accumulated Depreciation
	= $60,000 - $55560
	=$4,440
Market value (MV)	=$10,000
NSV of project old asset	= MV - tax rate (MV-BV)
	=$10,000 - .4 *($10,000- $4,440)
	=$7,776

Recovered Net working capital = $5,000

Therefore, Terminal cash flow =$7,776 + $5,000 = $12776

D.) NPV calculation

Years	0	1	2	3
initial investment	(60,000)
change in net working capital	(5,000)			5000
operating cash flow		$25,992	$28,680	$21,552
NSV of new equipment				7776
Total cash flows	(65,000)	$25,992	$28,680	$34,328
PVIF @   12%	1	0.8929	0.7972	0.7118
Discounted cash flows	(65,000)	$23,207	$22,864	$24,434
Sum of Discounted cash flows from year 1 to 6 = $70,505

NPV = Sum of Discounted cash flows from year 1 to 3 – initial outflow

NPV = $70,505 – 65,000

NPV = $5,505