Question

1.) What is the depreciation expense in Year 1 (in $s) and after tax OCF in year 1?

2.) What is the depreciation expense in Year 2 (in $s) and after tax OCF in year 2?

3.) What is the depreciation expense in Year 3 (in $s) and after tax OCF in year 3?

4.) What is the after tax salvage value of the equipment at the end of year 3

5.)What is the terminal cash flow (the last cash flow of the project not including the OCF)?

6.) What is the initial investment in this project (enter as a negative number)?

7.) What is the projects NPV?

Frito Lay is considering a new line of potato chips. This will be a three year project.

a. Frito Lay paid $1,000,000 last year to a winning person who thought of the new line of potato chips.

b. New equipment will cost $6,000,000 and depreciation is by the 3-year MACRS method. Purchase of the equipment will require an increase in net working capital of $600,000 at time 0 (which will be recaptured at the end of the project).

c. The new potato chips will generate an additional $5,000,000 in revenues in the first year, $4,000,000 in revenues in in the second year, and $2,000,000 in revenues the third (final) year revenues.

d. In addition to the additional revenues outlined in c. The new potato chips will decrease existing chip line revenues by $2,000,000 the first year, $1,000,000 the second year, and $500,000 the third year.

e. The new project is estimated to have expenses of $150,000 each year.

f. At the conclusion of the project, the equipment can be sold for $1,000,000.

g. The firm’s marginal tax rate is 20 percent, and the project’s cost of capital is 10 percent.

The following is the MACRS Depreciation Table:

Year	3-year	5-year	7-year
1	33.33%	20.00%	14.29%
2	44.44%	32.00%	24.49%
3	14.82%	19.20%	17.49%
4	7.41%	11.52%	12.49%
5		11.52%	8.93%
6		5.76%	8.93%
7			8.93%
8			4.45%

Answer 1

1).

Depreciation expense in year 1 = Cost of equipment x depreciation rate

                                                       = $ 6,000,000 x 33.33 % = $ 1,999,800

Computation of cash flow:

Revenue	$5,000,000
Less: expenses	$150,000
Gross profit	$4,850,000
Less: Lost revenue	$2,000,000
Less: Depreciation	$1,999,800
PBT	$850,200
Tax @ 20 %	$170,040
Net profit	$680,160
Add: Depreciation	$1,999,800
Cash Flow	$2,679,960

Depreciation expense in year 1 is $ 1,999,800 and after tax OCF is $2,679,960

2).

Depreciation expense in year 2 = Cost of equipment x depreciation rate

                                                       = $ 6,000,000 x 44.44 % = $ 2,666,400

Computation of cash flow:

Revenue	$4,000,000
Less: expenses	$150,000
Gross profit	$3,850,000
Less: Lost revenue	$1,000,000
Less: Depreciation	$2,666,400
PBT	$183,600
Tax @ 20 %	$36,720
Net profit	$146,880
Add: Depreciation	$2,666,400
Cash Flow	$2,813,280

Depreciation expense in year 2 is $ 2,666,400 and after tax OCF is $ 2,813,280

3).

Depreciation expense in year 3 = Cost of equipment x depreciation rate

                                                       = $ 6,000,000 x 14.82 % = $ 889,200

Computation of cash flow:

Revenue	$2,000,000
Less: expenses	$150,000
Gross profit	$1,850,000
Less: Lost revenue	$500,000
Less: Depreciation	$889,200
PBT	$460,800
Tax @ 20 %	$92,160
Net profit	$368,640
Add: Depreciation	$889,200
Cash Flow	$1,257,840

Depreciation expense in year 3 is $ 889,200 and after tax OCF is $ 1,257,840

4).

Book value of equipment at the end of the project = Initial cost – accumulated depreciation

                                                                    = $ 6,000,000 - $ 1,999,800- $ 2,666,400 - $ 889,200

                                                                    = $ 6,000,000 - $ 5,555,400 = $ 444,600

Proceeds from sales of equipment at the end of the project

= Market value – [(Market value – Book value) x Tax rate]

= $ 1,000,000 – [($ 1,000,000 - $ 444,600) x 0.2]

= $ 1,000,000 – ($ 555,400 x 0.2)

= $ 1,000,000 – $ 111,080

= $ 888,920

After tax salvage value of equipment is $ 888,920

5).

Terminal cash flow = After tax salvage value of equipment + Working capital release

                                 = $ 888,920 + $ 600,000 = $ 1,488,920

6).

Initial investment = Cost of equipment + Working capital

                                 = - $ 6,000,000 - $ 600,000 = - $ 6,600,000

7).

NPV = FV of cash inflow – Initial investment

Year	Cash Flow (C)	PV Factor Computation	PV Factor @ 10% (F)	PV (=C x F)
0	($6,600,000)	1/(1+0.1)^0	1	($6,600,000)
1	$2,679,960	1/(1+0.1)^1	0.909090909090909	$2,436,327
2	$2,813,280	1/(1+0.1)^2	0.826446280991735	$2,325,025
3	*$2,746,760	1/(1+0.1)^3	0.751314800901578	$2,063,681
			NPV	$225,034

*Total cash flow in year 3 = OCF in year 3 + Terminal cash flow

                                            = $1,257,840 + $ 1,488,920 = $ 2,746,760

NPV of the project is $ 225,034