Question

Project cash flow and NPV. The managers of Classic Autos Incorporated plan to manufacture classic Thunderbirds (1957 replicas). The necessary foundry equipment will cost a total of $4,200,000 and will be depreciated using a five-year MACRS life rate. The sales manager has an estimate for the sale of the classic Thunderbirds. The annual sales volume will be as follow:

Year one: 260 Year four: 380

Year two: 290 Year five: 300

Year three: 330

If the sales price is $30,000 per car, variable costs are $18,000 per car, and fixed costs are $1,200,000 annually, what is the annual operating cash flow if the tax rate is 30%?

The equipment is sold for salvage for $500,000 at the end of year five. Net working capital increases by $500,000 at the beginning of the project? (year 0) and is reduced back to its original level in the final year. Find the internal rate of return for the project using the incremental cash flows. (Hint: Find the annual operating cash flow of the project for years 1-5 and making an income statement)?

Answer 1

Step 1: Calculate Annual Operating Cash Flows

The annual operating cash flows are determined with the use of following table:

	Year
	1	2	3	4	5
Sales	7,800,000 (260*30,000)	8,700,000 (290*30,000)	9,900,000 (330*30,000)	11,400,000 (380*30,000)	9,000,000 (300*30,000)
Less Cost of Goods Sold	4,680,000 (260*18,000)	5,220,000 (290*18,000)	5,940,000 (330*18,000)	6,840,000 (380*18,000)	5,400,000 (300*18,000)
Fixed Costs	1,200,000	1,200,000	1,200,000	1,200,000	1,200,000
Depreciation	840,000 (4,200,000*20%)	1,344,000 (4,200,000*32%)	806,400 (4,200,000*19.20%)	483,840 (4,200,000*11.52%)	483,840 (4,200,000*11.52%)
EBIT	1,080,000	936,000	1,953,600	2,876,160	1,916,160
Less Taxes	324,000	280,800	586,080	862,848	574,848
Net Income	756,000	655,200	1,367,520	2,013,312	1,341,312
Add Depreciation	840,000	1,344,000	806,400	483,840	483,840
Operating Cash Flow	$1,596,000	$1,999,200	$2,173,920	$2,497,152	$1,825,152

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Step 2: Calculate Incremental Cash Flows

The value of incremental cash flow for each year is arrived as follows:

	Year
	0	1	2	3	4	5
Initial Investment	-4,200,000
Change in Net Working Capital	-500,000	0	0	0	0	500,000
Operating Cash Flow		1,596,000	1,999,200	2,173,920	2,497,152	1,825,152
After-Tax Salvage Value [500,000 - 30%*(500,000 - 500,000 - 4,200,000*5.76%)]		0	0	0	0	422,576
Total Incremental Cash Flows	-$4,700,000	$1,596,000	$1,999,200	$2,173,920	$2,497,152	$2,747,728

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Step 3: Calculate IRR

IRR is the minimum rate of return acceptable from a project. It can be calculated with the use of IRR function/formula of EXCEL/Financial Calculator. The basic formula for calculating IRR is given as below:

NPV = 0 = Incremental Cash Flow Year 0 + Incremental Cash Flow Year 1/(1+IRR)^1 + Incremental Cash Flow Year 2/(1+IRR)^2 + Incremental Cash Flow Year 3/(1+IRR)^3 + Incremental Cash Flow Year 4/(1+IRR)^4 + Incremental Cash Flow Year 5/(1+IRR)^5

IRR is calculated with the use of EXCEL as follows:

where IRR = IRR(B2:B7) = 33.13% (answer)