Question

Arnold Inc. is considering a proposal to manufacture​ high-end protein bars used as food supplements by body builders. The project requires use of an existing​ warehouse, which the firm acquired three years ago for $ 1 million and which it currently rents out for $110,000. Rental rates are not expected to change going forward. In addition to using the​ warehouse, the project requires an upfront investment into machines and other equipment of $1.5 million. This investment can be fully depreciated​ straight-line over the next 10 years for tax purposes. ​ However, Arnold Inc. expects to terminate the project at the end of eight years and to sell the machines and equipment for $538,000. Finally, the project requires an initial investment into net working capital equal to 10 percent of predicted​ first-year sales.​ Subsequently, net working capital is 10 percent of the predicted sales over the following year. Sales of protein bars are expected to be $4.9 million in the first year and to stay constant for eight years. Total manufacturing costs and operating expenses​ (excluding depreciation) are 80 percent of​ sales, and profits are taxed at 30 percent.

a. What are the free cash flows of the​ project?

b. If the cost of capital is 15 %​, what is the NPV of the​ project?

a. What are the free cash flows of the​ project?

The FCF for year 0 is ​$ million. ​ (Round to three decimal​ places.)

The FCF for years​ 1-7 is $ million. ​ (Round to three decimal​ places.)

The FCF for year 8 is $ million. ​ (Round to three decimal​ places.)

b. If the cost of capital is

15 %​, what is the NPV of the​ project?

The NPV of the project is $ million. ​ (Round to three decimal​ places.)

Answer 1

a)
1]	Cost of machines and other equipments	$            1.500
	Increase in NWC = 4.9*10% =	$            0.490
	FCF for year 0	$            1.990
2]	Sales	$            4.900
	-Manufacturing and operating expenses [excl. depn]	$            3.920
	-Depreciation [1.5/10]	$            0.150
	-Loss of rental income	$            0.110
	=Incremental NOI	$            0.720
	-Tax at 30%	$            0.216
	=NOPAT	$            0.504
	+Depreciation	$            0.150
	=FCF for years 1 to 7	$            0.654
3]	Operating cash flow for year 8	$            0.654
	Recovery of NWC	$            0.490
	After tax salvage value of machines = 0.538-(0.538-0.300)*30% =	$            0.467
	Note: Book value of machine = 1.500-0.150*8 = 0.300]
	FCF for year 8	$            1.611
b]	PV of FCF for years 1 to 7 = 0.654*(1.15^7-1)/(0.15*1.15^7) =	$            2.721
	PV of FCF for year 8 = 1.611/1.15^8 =	$            0.527
	Sum of PVs of cash inflows	$            3.248
	Less: FCF for year 0	$            1.990
	NPV	$            1.258