Question

Revenues generated by a new fad product are forecast as follows: Year Revenues $60,000 30,000 20,000 10,000 m Thereafter 0 Expenses are expected to be 50% of revenues, and working capital required in each year is expected to be 10% of revenues in the following year. The product requires an immediate investment of $54,000 in plant and equipment. Required: a. What is the initial investment in the product? Remember working capital. b. If the plant and equipment are depreciated over 4 years to a salvage value of zero using straight-line depreciation, and the firm's tax rate is 20%, what are the project cash flows in each year? Assume the plant and equipment are worthless at the end of 4 years. c. If the opportunity cost of capital is 10%, what is the project's NPV? d. What is project IRR?

Answer 1

solution: Plant equipment working capital =60000*10% Initial investment 54000 6000 60000 b) Revenue Less : expense (Revenue x 50%) Less : Depreciation=54000/4 income before tax Less : tax at 20% net income Add : Depreciation OCF working capital changes net cash flow 1 60000 -30000 -13500 16500 -3300 13200 13500 26700 3000 29700 2 30000 -15000 -13500 1500 -300 1200 13500 14700 1000 15700 3 20000 -10000 -13500 -3500 700 -2800 13500 10700 1000 11700 10000 -5000 -13500 -8500 1700 -6800 13500 6700 1000 7700 4 -6000 net cash flow x discount factor at 10% PV NPV 0 -60000 1.00000 -60,000.00 |- 5,975.21 1 29700 0.90909 27,000.00 2 15700 0.82645 12,975.21 3 11700 0.75131 8,790.38 7700 0.68301 5,259.20

IRR using trial and error method year cash flow discount factor at 5% PV at 5% discount factor at 4% PV at 4% c=a*b b c=a*b -60000 1.00000-60,000.00 1.00000 - 60,000.00 1 29700 0.95238 28,285.71 0.96154 28,557.69 2 15700 0.90703 14,240.36 0.92456 14,515.53 3 11700 0.86384 10,106.90 0.88900 10,401.26 4 7700 0.82270 6,334.81 0.85480 6,581.99 - 1,032.21 NPV 56.47 By interpolation: IRR = 4.05% 5-1032.21/(1032.21+56.47)) mt NPV