Question

Arnold Inc. is considering a proposal to manufacture high-end protein bars used as food supplements by body builders. The project requires use of an existing warehouse, which the firm acquired three years ago for $ 2 million and which it currently rents out for $ 100,000. Rental rates are not expected to change going forward. In addition to using the warehouse, the project requires an upfront investment into machines and other equipment of $ 1.4 million. This investment can be fully depreciated straight-line over the next 10 years for tax purposes. However, Arnold Inc. expects to terminate the project at the end of eight years and to sell the machines and equipment for $ 578,000. Finally, the project requires an initial investment into net working capital equal to 10 percent of predicted first-year sales. Subsequently, net working capital is 10 percent of the predicted sales over the following year. Sales of protein bars are expected to be $ 4.6 million in the first year and to stay constant for eight years. Total manufacturing costs and operating expenses (excluding depreciation) are 80 percent of sales, and profits are taxed at 30 percent.

a. What are the free cash flows of the project?

b. If the cost of capital is 15 % , what is the NPV of the project?

a. What are the free cash flows of the project?

The FCF for year 0 is $( ) million. (Round to three decimal places.)

The FCF for years 1-7 is $ ( ) million. (Round to three decimal places.)

The FCF for year 8 is $ ( ) million. (Round to three decimal places.)

b. If the cost of capital is 15 % , what is the NPV of the project?

The NPV of the project is $ （ ）million. (Round to three decimal places.)

Answer 1

a). Free Cash Flows (All numbers in $ million):

Formula	FCF in year 0:
	Capex	(1.400)
10% of Year 1 sales	Investment in NWC	(0.460)
	FCF in year 0:	(1.860)

Formula	FCF (Year 1 - 7):
	Sales (S)	4.600
80%*S	COGS	3.680
SL over 10 years	Depreciation (D)	0.140
	Rental loss (L)	0.100
(S-COGS-D-L)	EBIT	0.680
30%*EBIT	Tax @30%	0.204
(EBIT-Tax)	Unlevered net income (NI)	0.476
	Add: Depreciation (D)	0.140
(No capex or NWC investment)	OCF (or FCF)	0.616

Formula	FCF in Year 8:
	OCF	0.616
	Salvage value (SV)	0.578
Capex - (8*D)	Book value (at the end of Year 8) (BV)	0.280
(SV - (SV-BV)*30%)	After-tax salvage value (ASV)	0.489
	Return of NWC	0.460
(OCF+ASV+NWC)	FCF	1.565

b). NPV = $1.214 million

NPV	FCF	PV of FCF
Year 0	(1.860)	(1.860)
Year 1 - 7	0.616	2.563
Year 8	1.565	0.511
	NPV	1.214