Question

Please solve and explain:

After paying $3 million for a feasibility study, Stanley wrote a proposal with the following cash flow estimates for a 25-year capital project. Equipment cost: $34 million, Shipping costs: $1 million, Installation: $19 million, Salvage: $4, Working capital investment: $2 million, Revenues are expected to increase by $20 million per year and cash operating expenses by $9 million per year. The firm’s marginal tax rate is 40 percent, its weighted average cost of capital is 9%, and the firm requires a 3 year payback. Assume conventional straight line depreciation.

Evaluate the project using NPV, IRR, PI, and PB.

Answer:

IO = $56 million

Δ D = $2.16 million

NCF1-25 = $7.464 million

NCF25 = $4.4 million

NPV = $17.826 million > 0, so Accept

IRR = 12.71% > 9%, so Accept

PI = 1.32 > 1, so Accept

PB = 7.50 years > 3 so Reject

ACCEPT the project; PB can lead to wrong decisions

Answer 1

We calculate the Cash flows as under

Year	Initial cost	Salvage after tax =Salvage*(1-tax)	Net revenue after tax = (Revenue-cost)*(1-tax)	Tax shield= depreciation*Tax	Working capital	Net Cash flow	Cumulative CF
0	-54				-2	-56	-56
1			6.6	0.864		7.464	-48.536
2			6.6	0.864		7.464	-41.072
3			6.6	0.864		7.464	-33.608
4			6.6	0.864		7.464	-26.144
5			6.6	0.864		7.464	-18.68
6			6.6	0.864		7.464	-11.216
7			6.6	0.864		7.464	-3.752
8			6.6	0.864		7.464	3.712
9			6.6	0.864		7.464	11.176
10			6.6	0.864		7.464	18.64
11			6.6	0.864		7.464	26.104
12			6.6	0.864		7.464	33.568
13			6.6	0.864		7.464	41.032
14			6.6	0.864		7.464	48.496
15			6.6	0.864		7.464	55.96
16			6.6	0.864		7.464	63.424
17			6.6	0.864		7.464	70.888
18			6.6	0.864		7.464	78.352
19			6.6	0.864		7.464	85.816
20			6.6	0.864		7.464	93.28
21			6.6	0.864		7.464	100.744
22			6.6	0.864		7.464	108.208
23			6.6	0.864		7.464	115.672
24			6.6	0.864		7.464	123.136
25		2.4	6.6	0.864	2	11.864	135

NPV	17.826
IRR	12.71%
PI	1.32
Payback	7.50 years

NPV is positive so the project should be accepted.

Irr is more than WACC, hence accept the project.

PI is more than 1, so the project should be accepted.

As per payback, the project should be rejected but this is a wrong decision since NPV is positive.

So the project should be accepted.

WORKINGS

Payback = Year in which Cumulative CF is last negative -(Last negative cumulative CF/ CF of next year