Question

Question: Artistic Clothing is considering an extension project which includes the construction of a new manufacturing warehouse. The required initial investment for the construction is $2 million. the warehouse will be depreciated over 10 years on a straight-line basis with no residual value at the end of year 10. Also, company also plans to use its own land for the project which is currently hired to other company to use as a warehouse. The estimated rental income that will be missed over the project life is $300,000 valued as of today. To start the production, Artistic Clothing needs to invest in net working
capital the total amount of $200,000 at the beginning of the project. This investment will be recovered at the end of the project.

Company also expects to generate an annual revenue of $650,000, its associated cost of sales and operating expense are $250,000. Tax rate is 30%.

a. Determine the cash flows of the project from year 1 to year 10.

b. If company requires a rate of return of 10% from the project, should this project be accepted?

c. Calculate the payback period. If the company requires a payback period of less than 6 years, should the project be accepted?

Answer 1

a

Time line		0	1	2	3	4	5	6	7	8	9	10
Land cost		-300000
Cost of new machine		-2000000
Initial working capital		-200000
=Initial Investment outlay		-2500000
Sales			650000	650000	650000	650000	650000	650000	650000	650000	650000	650000
Profits	Sales-variable cost		650000	650000	650000	650000	650000	650000	650000	650000	650000	650000
Operating cost			-250000	-250000	-250000	-250000	-250000	-250000	-250000	-250000	-250000	-250000
-Depreciation	Cost of equipment/no. of years		-200000	-200000	-200000	-200000	-200000	-200000	-200000	-200000	-200000	-200000
=Pretax cash flows			200000	200000	200000	200000	200000	200000	200000	200000	200000	200000
-taxes	=(Pretax cash flows)*(1-tax)		140000	140000	140000	140000	140000	140000	140000	140000	140000	140000
+Depreciation			200000	200000	200000	200000	200000	200000	200000	200000	200000	200000
=after tax operating cash flow			340000	340000	340000	340000	340000	340000	340000	340000	340000	340000
reversal of working capital												200000
+Tax shield on salvage book value	=Salvage value * tax rate											0
=Terminal year after tax cash flows												200000
Total Cash flow for the period		-2500000	340000	340000	340000	340000	340000	340000	340000	340000	340000	540000

b

Total Cash flow for the period		-2500000	340000	340000	340000	340000	340000	340000	340000	340000	340000	540000
Discount factor=	(1+discount rate)^corresponding period	1	1.1	1.21	1.331	1.4641	1.61051	1.771561	1.948717	2.1435888	2.357948	2.593742
Discounted CF=	Cashflow/discount factor	-2500000	309090.9	280991.7	255447.03	232224.57	211113.25	191921.14	174473.8	158612.51	144193.2	208193.4
NPV=	Sum of discounted CF=	-333738.5262

Reject project as NPV is negative

c

Project
Year	Cash flow stream	Cumulative cash flow
0	-2500000	-2500000
1	340000	-2160000
2	340000	-1820000
3	340000	-1480000
4	340000	-1140000
5	340000	-800000
6	340000	-460000
7	340000	-120000
8	340000	220000
9	340000	560000
10	540000	1100000

Payback period is the time by which undiscounted cashflow cover the intial investment outlay

this is happening between year 7 and 8

therefore by interpolation payback period = 7 + (0-(-120000))/(220000-(-120000))

7.35 Years

Reject project as payback period is more than 6 years