Question

GnuYak Industries is considering a new project that will last for three years. This project requires an initial investment in a machine that costs £90,000 immediately (year 0) and will be depreciated in straight line over its three-year life to a residual value of 0. The management expects this project will result in sales of £100,000 and cost of goods sold will be 50% of sales each year. This project also requires a total net working capital of £10,000 in year 0 which will be fully recovered in year 3. GnuYak is in the 35% corporate tax bracket.

a. Calculate the total Free Cash Flows for each year of this new project.

b. Suppose that the appropriate discount rate for this project is 10%, calculate the NPV of this project.

Answer 1

Time line		0	1	2	3
Cost of new machine		-90000
Initial working capital		-10000
=Initial Investment outlay		-100000
Sales			100000	100000	100000
Profits	Sales-variable cost		50000	50000	50000
-Depreciation	Cost of equipment/no. of years		-30000	-30000	-30000
=Pretax cash flows			20000	20000	20000
-taxes	=(Pretax cash flows)*(1-tax)		13000	13000	13000
+Depreciation			30000	30000	30000
=a. FCF			43000	43000	43000
reversal of working capital					10000
+Tax shield on salvage book value	=Salvage value * tax rate				0
=Terminal year after tax cash flows					10000
Total Cash flow for the period		-100000	43000	43000	53000
Discount factor=	(1+discount rate)^corresponding period	1	1.1	1.21	1.331
Discounted CF=	Cashflow/discount factor	-100000	39090.90909	35537.19	39819.684
b. NPV=	Sum of discounted CF=	14447.78