Question

) Gateway Communications is considering a 5-year project with an initial fixed asset cost of $2.4 million which will be depreciated straight-line to a zero book value over its 8-year useful life. At the end of the project the equipment will be sold for an estimated $400,000. The firm expects the project to generate sales of $1,200,000 each year. Total costs are expected to be $350,000 each year. It is expected that working capital related to this project is equal to $350,000 throughout the life of the project. The investment in working capital will be recouped when the project ends. The firm’s marginal tax rate is 21%. The required return on this project is 14 percent, compounded weekly. a) Using the NPV Decision Rule, should this project be accepted? Why or why not? b) Using the Profitability Index Rule, should this project be accepted? Why or why not?

Answer 1

1)	Annualized discount rate = (1+0.14/52)^52-1 =	15.01%
2)	Initital investment = 2400000+350000 =	$   27,50,000
3)	Annual operating cash flows:
	Sales	$   12,00,000
	Costs other than depreciation	$     3,50,000
	Depreciation [2400000/8]	$     3,00,000
	EBIT	$     5,50,000
	Tax at 21%	$     1,15,500
	NOPAT	$     4,34,500
	Add: Depreciation	$     3,00,000
	OCF	$     7,34,500
4)	Terminal non-operating cash flows:
	Recapture of NWC	$     3,50,000
	After tax sale value of equipment = 400000*(1-21%) =	$     3,16,000
	Terminal non-operating cash flows	$     6,66,000
a)	NPV:
	PV of annual OCF = 734500*(1.1501^8-1)/(0.1501*1.1501^8) =	$   32,94,854
	PV of terminal cash flows = 666000/1.1501^8 =	$     2,17,565
	Sum of PV of cash inflows	$   35,12,419
	Less: Initial investment	$   27,50,000
	NPV	$     7,62,419
	As NPV is positive the project should be accepted.
b)	PI:
	Profitability index = PV of cash inflows/Initial investment
	= 3512419/2750000 =	1.28
	As PI is greater than 1, the project should be accepted.