Question
In: Finance
You work for a small pottery company that is considering selling products on the Internet. After...
You work for a small pottery company that is considering selling products on the Internet. After careful analysis, you estimate that the firm would need to spend $80,000 developing a Web site and integrating it with the firm’s inventory system. For tax purposes, this investment can be depreciated using straight-line depreciation over 4 years (the salvage value is zero). The Web site will generate an additional $100,000 in sales. The costs of good sold will equal $60,000. To support these sales, inventory will have to increase by $8,000 in the first year. Inventory will remain at this level until the end of the project in 4 years, at which time it will drop back to its original level. The tax rate is 40% and the cost of capital is 10%. Should the firm proceed with this project?
Solutions
Expert Solution
|
Calculation of NPV at discount rate of 10% |
||||||
| 0 | 1 | 2 | 3 | 4 | ||
|
Initial cost |
-$80,000.00 | |||||
|
Investment in inventory |
||||||
|
Additional Sales |
$100,000.00 | $100,000.00 | $100,000.00 | $100,000.00 | ||
|
Less :cost of goods sold |
-$60,000.00 | -$60,000.00 | -$60,000.00 | -$60,000.00 | ||
|
Less : Depreciation |
-$20,000.00 | -$20,000.00 | -$20,000.00 | -$20,000.00 | ||
| (80000/4) | ||||||
|
Profit before tax |
$20,000.00 | $20,000.00 | $20,000.00 | $20,000.00 | ||
|
Less : Tax @ 40% |
-$8,000.00 | -$8,000.00 | -$8,000.00 | -$8,000.00 | ||
|
Profit after tax |
$12,000.00 | $12,000.00 | $12,000.00 | $12,000.00 | ||
|
Add : depreciation |
$20,000.00 | $20,000.00 | $20,000.00 | $20,000.00 | ||
|
(as it is non-cash item) |
||||||
|
Less : investment in inventory in 1st year |
-8000 | |||||
|
Add : Inventory value recovered |
- | - | - | $8,000.00 | ||
|
__________________________________________ |
||||||
|
Free cash flow |
-$80,000.00 | $24,000.00 | $32,000.00 | $32,000.00 | $40,000.00 | |
| * | ||||||
|
Present value factor @ 10% |
1 | 0.9090909091 | 0.826446281 | 0.7513148009 | 0.6830134554 | |
|
Present value of free cash flow |
-$80,000.00 | $21,818.18 | $26,446.28 | $24,042.07 | $27,320.54 | |
|
Net present value |
$19,627.07 | |||||
|
(sum of present value of all free cash flows) |
||||||
|
So, NPV of project is $19,627.07. So project should be accepted. |
||||||
|
Note : Depreciation shall be added as it is relevant only for tax calculation. |
||||||
|
(2) P.V.F. formula = 1/(1+i)^n |
||||||
|
for 1st year = 1/(1+0.10)^1 = |
0.9090909091 | |||||
|
for 2nd year = 1/(1+0.10)^2= |
0.826446281 | |||||
|
and so on. |
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