Question

Phone Home, Inc. is considering a new 4-year expansion project that requires an initial fixed asset investment of $3 million. The fixed asset will be depreciated straightline to a zero book value over its 4-year tax life. The firm expects to be able to sell these assets for $231,000 at the end of the project. It is expected that this project will generate new sales of $2,640,000. The firm is also expecting to lose sales of approximately $420,000 each year from a competing product during the life of this project. The project requires an initial investment in net working capital of $330,000, all of which will be recovered at the end of the project. The firm’s average tax rate is 32% and the marginal tax rate is 35%. The required return for this project is 15%. What is the net present value of this project? Should the project be accepted? Why or why not?

Answer 1

Calculating Initial investment in year 0

Initial Fixed asset investment = 3 million = $3000000

Initial investment in working capital = 330000

Initial investment in year 0 = Initial fixed asset investment + Investment in working capital = 3000000 + 330000 = 3330000

Calculating After tax operating cash flows

Annual depreciation = (Initial fixed asset investment - Book value at end of 4 years) / No of years = (3000000 - 0) / 4 = 750000

Incremental sales = New sales - loss of sale from competing project = 2640000 - 420000 = 2220000

Incremental costs = 0

After tax operating cash flow in year 1 to 4 = (Incremental sales - incremental costs - depreciation)(1-tax rate) + depreciation = (2220000 - 0 - 750000)(1-32%) + 750000 = 1470000 x 68% + 750000 = 999600 + 750000 = 1749600

Calculating terminal cash flow in year 4

Salvage value of fixed asset at end of 4 years = 231000

Terminal cash flow in year 4 = Salvage value of fixed asset at end of 4 years + Recovery of net working capital + tax on gain from sale of assets = Salvage value of fixed asset at end of 4 years + Recovery of net working capital + tax rate (Salvage value of fixed asset at the end of 4 years - Book value of fixed asset at the end of 4 years) = 231000 + 330000 + 32%(231000 - 0) = 231000 + 330000 + 73920 = 634920

Net present value of project = - initial investment in year 0 + Sum of present of values of after tax operating cash flows for year 1 to 4 discounted at 15% + present value of terminal cash flow in year 4 at 15%

= - 3330000 + 1749600 / (1 + 15%) + 1749600 / (1+ 15%)² + 1749600 / (1+ 15%)³ + 1749600 / (1+ 15%)⁴ + 634920 / (1+ 15%)⁴

= -3330000 + 1521391.3043 + 1322948.9603 + 1150390.4002 + 1000339.4784 + 363017.5706 = 2028087.7138 = 2028087.71

Hence Net present value of project = $2028087.71

Project should be accepted because the net present value of the project is positive