Question

Arnold Inc. is considering a proposal to manufacture​ high-end protein bars used as food supplements by body builders. The project requires use of an existing​ warehouse, which the firm acquired three years ago for $1 million and which it currently rents out for $115,000. Rental rates are not expected to change going forward. In addition to using the​ warehouse, the project requires an upfront investment into machines and other equipment of $1.5 million. This investment can be fully depreciated​ straight-line over the next 10 years for tax purposes. ​ However, Arnold Inc. expects to terminate the project at the end of eight years and to sell the machines and equipment for $488,000.​ Finally, the project requires an initial investment into networking capital equal to 10 percent of predicted​ first-year sales. ​ Subsequently, net working capital is 10 percent of the predicted sales over the following year. Sales of protein bars are expected to be $4.8 million in the first year and to stay constant for eight years. Total manufacturing costs and operating expenses​ (excluding depreciation) are 80 percent of​ sales, and profits are taxed at 30 percent.

a. What are the free cash flows of the​ project?

b. If the cost of capital is 15%​, what is the NPV of the​ project?

Answer 1

Answer:

Part a:

	0	1	2	3	4	5	6	7	8
Sales		4800000	4800000	4800000	4800000	4800000	4800000	4800000	4800000
Less: Manufacturing and operating costs(80% of sales)		-3840000	-3840000	-3840000	-3840000	-3840000	-3840000	-3840000	-3840000
Less; Rent lost		-115000	-115000	-115000	-115000	-115000	-115000	-115000	-115000
Less: Depreciation = 15000000/10		-150000	-150000	-150000	-150000	-150000	-150000	-150000	-150000
Income before tax		695000	695000	695000	695000	695000	695000	695000	695000
Less: tax@ 30%		-208500	-208500	-208500	-208500	-208500	-208500	-208500	-208500
Net Income		486500	486500	486500	486500	486500	486500	486500	486500
Add: Depreciation		150000	150000	150000	150000	150000	150000	150000	150000
OCF		636500	636500	636500	636500	636500	636500	636500	636500
after tax sale value of machine**									431600
Cost of machine	-1500000
Changes in working capital = 4800000*0.1	-480000								480000
Free cash flow	-1980000	636500	636500	636500	636500	636500	636500	636500	1548100

Part b:

	0	1	2	3	4	5	6	7	8
Free cash flow	-1980000	636500	636500	636500	636500	636500	636500	636500	1548100
x discount factor at 15%	1.00000	0.86957	0.75614	0.65752	0.57175	0.49718	0.43233	0.37594	0.32690
PV	-1980000	553481.305	481283.110	418511.48	363918.875	316455.07	275178.045	239285.81	506073.89
NPV	1174187.585

**after tax sale value of machine
sale value	488000
Book value =(1500000/10)*2	-300000
Gain on sale	188000
Tax on gain @ 30%	56400
after tax sale value of machine = 488000-56400	431600