Question

Down Under Boomerang, Inc. is considering a new three-year expansion project that requires an

initial fixed asset investment of $2.4 million. The fixed asset will be depreciated straight-line to

zero over its three-year tax life, after which it will be worthless. The project is estimated to

generate $2,050,000 in annual sales, with costs of $950,000. The tax rate is 35% and the

required return is 12 percent. Calculate the projects NPV and IRR.

Suppose that Down Under Boomerang is projected to grow at a rate of 4% after year 3. What

is the value of the firm?

Part 2

Suppose the project requires an initial investment in net working capital of

$285,000 and the fixed asset will have a market value of $225,000 at the end of the project.

What are the new NPV and IRR?

Now what is the value of the firm?

Answer 1

Part 1:

Depreciation = Investment/ Life

Depreciation = 2400000/ 3 =800000

Using this we calculate the NPV below:

Year	Remark	0	1	2	3
Sales	given		2050000	2050000	2050000
Cost	given		950000	950000	950000
Depreciation	calculated		800000	800000	800000
EBIT	Sales-Cost-Depreciation		300000	300000	300000
Tax	0.35xEBIT		105000	105000	105000
EAT	EBIT-Tax		195000	195000	195000
Depreciation	Added Back		800000	800000	800000
CF	EAT+Depreciation		995000	995000	995000
FCINV	given	-2400000
Total CF	CF+FCINV	-2400000	995000	995000	995000
Discount Factor formula	at 12%	1/1.12^0	1/1.12^1	1/1.12^2	1/1.12^3
Discount Factor		1	0.892857143	0.797193878	0.711780248
Discounted CF	CF x Discount Factor	-2400000	888392.8571	793207.9082	708221.3466
NPV	Sum of discounted CF	-10177.88812

• As NPV is negative this project is not worth investing in
• 
• 
• 

IRR is the rate at which NPV = 0 so using hit and trial or excel's goal seek function we can calculate the IRR. We know that at 12% NPV is negative so IRR should be a rate lower than that:

Year	Remark	0	1	2	3
Sales	given		2050000	2050000	2050000
Cost	given		950000	950000	950000
Depreciation	calculated		800000	800000	800000
EBIT	Sales-Cost-Depreciation		300000	300000	300000
Tax	0.35xEBIT		105000	105000	105000
EAT	EBIT-Tax		195000	195000	195000
Depreciation	Added Back		800000	800000	800000
CF	EAT+Depreciation		995000	995000	995000
FCINV	given	-2400000
Total CF	CF+FCINV	-2400000	995000	995000	995000
Discount Factor formula	at 12%	1/1.11.7530549540973^0	1/1.11.7530549540973^1	1/1.11.7530549540973^2	1/1.11.7530549540973^3
Discount Factor		1	0.894830124	0.80072095	0.716509227
Discounted CF	CF x Discount Factor	-2400000	890355.9732	796717.3457	712926.6811
NPV	Sum of discounted CF	0

IRR comes to 11.75305495%

Part2:

Depreciation calculation remains the same as in part 1

NPV calculation changes as follows:

Year	Remark	0	1	2	3
Sales	given		2050000	2050000	2050000
Cost	given		950000	950000	950000
Depreciation	calculated		800000	800000	800000
EBIT	Sales-Cost-Depreciation		300000	300000	300000
Tax	0.35xEBIT		105000	105000	105000
EAT	EBIT-Tax		195000	195000	195000
Depreciation	Added Back		800000	800000	800000
CF	EAT+Depreciation		995000	995000	995000
FCINV	given	-2400000
WCINV	given	-285000			285000
Tax on sale value	0.35x225000x-1				-78750
Sale Value	given				225000
Total CF	CF+FCINV+WCINV+Tax on sale value+Sale Value	-2685000	995000	995000	1426250
Discount Factor formula	at 12%	1/1.12^0	1/1.12^1	1/1.12^2	1/1.12^3
Discount Factor		1	0.892857143	0.797193878	0.711780248
Discounted CF	CF x Discount Factor	-2685000	888392.8571	793207.9082	1015176.578
NPV	Sum of discounted CF	11777.34375

• WCinv is an outflow in year0 while it is assumed that it is recovered in year3 so it is an inflow
• As the equipment is completely depreciated, entire market value is a profit on which a tax needs to be paid at 35% and it is an outflow
• Sale value in itself is an inflow
• As sale of equipment is not a long term occurrence and nor is the recovery of working capital investment, the value of the firm remains the same in this case as well.
• NPV is positive at the same discount rate so the project should be invested in

IRR can be calculated the same way:

Year	Remark	0	1	2	3
Sales	given		2050000	2050000	2050000
Cost	given		950000	950000	950000
Depreciation	calculated		800000	800000	800000
EBIT	Sales-Cost-Depreciation		300000	300000	300000
Tax	0.35xEBIT		105000	105000	105000
EAT	EBIT-Tax		195000	195000	195000
Depreciation	Added Back		800000	800000	800000
CF	EAT+Depreciation		995000	995000	995000
FCINV	given	-2400000
WCINV	given	-285000			285000
Tax on sale value	0.35x225000x-1				-78750
Sale Value	given				225000
Total CF	CF+FCINV+WCINV+Tax on sale value+Sale Value	-2685000	995000	995000	1426250
Discount Factor formula	at 12%	1/1.12.2398136836981^0	1/1.12.2398136836981^1	1/1.12.2398136836981^2	1/1.12.2398136836981^3
Discount Factor		1	0.890949448	0.793790918	0.70722758
Discounted CF	CF x Discount Factor	-2685000	886494.7004	789821.9636	1008683.336
NPV	Sum of discounted CF	0

It comes to 12.23981368% because the NPV was positive at 12%