Question

1. Firm AAA is considering a new three-year new project that requires an initial fixed asset investment of $2.28 million. The fixed asset will be depreciated straight-line to zero over its three-year tax life, after which time it will be worthless. The project is estimated to generate $2,120,000 in annual sales, with costs of $745,000. The project requires an initial investment in net working capital of $260,000, and the fixed asset will have a market value of $280,000 at the end of the project.

1. If the tax rate is 35 percent, what is the project’s year 0 net cash flow? And what are the free cash flow at Year 1? Year 2? Year 3
2. Should the firm accept the project if the required return rate is 15%? Why? Please show your calculation in details.

Answer 1

Years	Cash Flow
Project's year 0 net cash flow	-$25,40,000
Project's year 1 net cash flow	$11,59,750
Project's year 2 net cash flow	$11,59,750
Project's year 3 net cash flow	$16,01,750

Calculate of Annual Cash Flow

Annual Sales	$21,20,000
Less : Costs	$745,000
Less: Depreciation [$22,80,000/ 3 Years]	$760,000
Net Income Before Tax	$615,000
Less : Tax at 35%	$215,250
Net Income After Tax	$399,750
Add Back : Depreciation	$760,000
Annual Cash Flow	$11,59,750

Year 0 Cash outflow

Year 0 Cash outflow = Initial Investment + Working Capital

= $22,80,000 + $260,000

= $25,40,000

Year 1 Cash Flow = $11,59,750

Year 2 Cash Flow = $11,59,750

Year 3 Cash Flow = Annual Cash flow + Working Capital + Market Value after tax

= $11,59,750 + $260,000 + [$280,000 x (1 – 0.35)]

= $11,59,750 + $260,000 + $182,000

= $16,01,750

(b)-Net Present Value (NPV) of the Project

Year	Annual Cash Flow ($)	Present Value factor at 15%	Present Value of Cash Flow ($)
1	11,59,750	0.86956522	10,08,478.26
2	11,59,750	0.75614367	8,76,937.62
3	16,01,750	0.65751623	10,53,176.63
TOTAL			29,38,592.50

Net Present Value (NPV) = Present Value of annual cash inflows – Initial Investment

= $29,38,592.50 - $25,40,000

= $3,98,592.50

“Net Present Value (NPV) = $3,98,592.50”

DECISION

YES. The firm should accept the Project, since the Net Present Value of the Project is Positive $3,98,592.50.

NOTE

The Formula for calculating the Present Value Factor is [1/(1 + r)ⁿ], Where “r” is the Discount/Interest Rate and “n” is the number of years.