Question

RET Inc. currently has two products, low and high priced stoves. REX Inc. has decided to sell a new line of medium-priced stoves. Sales revenues for the new line of stoves are estimated at $600 a year. Variable costs are 60% of sales. The project is expected to last 10 years. Also, non-variable costs are $200 per year. The company has spent $100 in research and a marketing study that determined the company will have synergy gains/sales of $200 a year from sales of its existing high-priced stoves. The production variable cost of these sales is $100 a year.

The plant and equipment required for producing the new line of stoves costs $300 and will be depreciated down to zero over 30 years using straight-line depreciation. It is expected that the plant and equipment can be sold (salvage value) for $50 at the end of 10 years. The new stoves will also require today an increase in net working capital of $20 that will be returned at the end of the project.

The tax rate is 20 percent and the cost of capital is 10%.

1. What is the initial outlay (IO) for this project?

2. What is the annual Earnings before Interests, and Taxes (EBIT) for this project?                                    

3. What is the annual net operating profits after taxes (NOPAT) for this project?

4. What is the annual incremental net cash flow (operating cash flow: OCF) for this project?

5. What is the remaining book value for the plant at equipment at the end of the project?

6. What is the cash flow due to tax on salvage value for this project? Enter a negative # if it is a tax gain. For example, if your answer is a tax on capital gains of $3,004.80 then enter   -3,005 ; if your answer is a tax shelter from a capital loss of $1,000.20 then enter 1,000

7. What is the project's cash flow for year 10 for this project?

8. Is the Net Present Value (NPV) for this project positive or negative? Just write the word positive or negative

Answer 1

1. Initial outlay = Cost of project + Net working capital

= $300+$20

= $320

2. EBIT (at existing level)

Sale $600

Variable cost (60%) ($360)

Contribution $240

Cash fixed cost ($200)

EBDIT $40

Depriciation(300-50)/10 ($25)

EBIT $15

3. Calculating NOPAT

NOPAT = EBIT * (1-t)

= 15 * (1-0.2)

= $12

4. Calculation of annual incrimental OCF

Existing sales level Increased sales level

Sale $600 $800   

   Variable cost (60%) ($360) ($460)   

Contribution $240 $340

Cash fixed cost ($200) ($200)

EBDIT $40 $140

Hence Incremental EBDIT = Increased EBDIT - Existing EBDIT

= 140-40

= $100

Incremental OCF = [Incrimental EBDIT-Incrimental Depriciation](1-t)+ Incrimental Depriciation

= [100-0](1-0.2)+0

= $80

5. Calculation of remaining book value for the plant at equipment at the end of the project

Total cost - Depriciation for 10 years

300-250 = $50

6. alculation of cash flow due to tax on salvage value for this project

Book Value after 10 years = $50

Salvage value = ($50)

Capital Gain Nil

Tax Nil

Net Salvage Value = $50

7. Calculation of project's cash flow for year 10 for this project =

= [Incrimental OCF * PVCF(10%,10)] + [(50+20)*PVCI(10%,10)]

= [$80 * 6.14] + [70*0.39]

= 491.2 + 27.3

= $518.5

8. Net Present Value (NPV) for this project is "Positive".