The firm Gelati-Banking (GB) is considering a project with the following characteristics. Sales will be $100...

The firm Gelati-Banking (GB) is considering a project with the following characteristics. Sales will be $100 MM for sure in the first year and grow 10% in the second year; thereafter, the long term growth rate is 3%. Gross Profit Margin (Gross Profit over Sales) will be 20%. Depreciation will be $10 MM each year for the next two years. Working Capital held for the project will have to be 10% of sales. Additional CAPX each year will be $11MM in year 1 and $12 MM in year 2. All cash flows defined here are deterministic and will go on indefinitely. Interest rates are as follows: 3-month t-bill is 3%, the 2 year treasury is 4% and the long bond (30-year) is trading at 5% per year. The Corporate Tax Rate is 40%. What would the investment need to be for this project to be breakeven (ignoring depreciation effects of the investment)? Assume that 1) Everything grows at 3% per year from year 2 onwards to infinity; and 2) The cash flow stream that goes from time 0 on indefinitely is similar in nature to a long term treasury bond.

Expert Solution

Year	1	2	3	4	5	6
Sales	100.00	110.00	113.30	116.70	120.20	123.81
Profit	20.00	22.00	22.66	23.34	24.04	24.76
Capital Expense	- 11.00	- 12.00	-12.36	-12.73	-13.11	-13.51
Working Capital	-10.00	-11.00	-11.33	-11.67	-12.02	-12.38
Change in Working Capital	-10.00	-1.00	-0.33	-0.34	-0.35	-0.36
Depriciation	-10.00	-10.00	-10.30	-10.61	-10.93	-11.26
Earnings before interest and taxes	10.00	12.00	12.36	12.73	13.11	13.51
Taxes	-4.00	-4.80	-4.94	-5.09	-5.25	-5.40
Net Cash flow	5.00	14.20	15.33	15.79	16.26	16.75

From the above table , it is clear that the project will provide net cash flow of $ 5 MM at the end of year 1 . In year 2, net cash flow will be $ 14.20 MM and in year 3 net cash flow will be $ 15.33 MM. The cash flow will grow at 3 % annually from year 3 onwards. The project will be at breakeven when NPV will be greater than 0 .

NPV = - investment + 5/1.03 + 14.2/(1.04)² + 15.326 / (0.05 - 0.03) > 0

(1.05)³

The investment will be less than $ 679.94 MM. At time 0 , the project will be at breakeven when the investment invested intially will be less than $ 669.94 MM.

jeff jeffy answered 2 years ago

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