Question

PC shopping Network may upgrade its modern pool. A new modern pool can be installed today for &160 million. It will be depreciated straight line to zero over a four-year useful life.

the total amount of working capital required by year is as follows:

year 0: $10,000,000 year 1: $7,200,000 Year 2: $6,000,000 year 3: $0

The new equipment will enable the firm to increase sales by $100 million each year for the next three years. It will also decrease fixed cost by $10 million. Variable cost is 40 percent of sales. At the end of the three year, it is estimated that you will receive $5 million when you sell the equipment. Assume the firm has a 35 percent tax rate. The capital structure of the company is 100 percent equity. The company's stock has a beta of 1.2, the expected return on the market portfolio os 10% and the risk-free rate is 3 percent. Should you replace the current modern pool? Calculate the cash flow from assets and use NPV calculations to support your answer. Assume the company judges the modern poo project as being an average risk

Answer 1

As per CAPM

expected return = risk-free rate + beta * (expected return on the market - risk-free rate)

Expected return% = 3 + 1.2 * (10 - 3)

Expected return% = 11.4

Time line		0	1	2	3
Cost of new machine		-160000000
Initial working capital		-10000000
=Initial Investment outlay		-170000000
						100.00%
Sales			100000000	100000000	100000000
Profits	Sales-variable cost		60000000	60000000	60000000
+Decrease in Fixed cost			10000000	10000000	10000000
-Depreciation	Cost of equipment/no. of years		-40000000	-40000000	-40000000	40000000	=Salvage Value
-working capital to be maintained			-7200000	-6000000	0
=Pretax cash flows			22800000	24000000	30000000
-taxes	=(Pretax cash flows)*(1-tax)		14820000	15600000	19500000
+Depreciation			40000000	40000000	40000000
=after tax operating cash flow			54820000	55600000	59500000
reversal of working capital					23200000
+Proceeds from sale of equipment after tax	=selling price* ( 1 -tax rate)				3250000
+Tax shield on salvage book value	=Salvage value * tax rate				14000000
=Terminal year after tax cash flows					40450000
Total Cash flow for the period		-170000000	54820000	55600000	99950000
Discount factor=	(1+discount rate)^corresponding period	1	1.114	1.240996	1.3824695
Discounted CF=	Cashflow/discount factor	-170000000	49210053.86	44802722.97	72298157
NPV=	Sum of discounted CF=	-3689066.267

Donot replace as NPV is negative