Question

caprai vuugtung itan Cildpel ASSighter Webmasters.com has developed a powerful new server that would be used for corporations Internet activities. It would cost $9 million at Year O to buy the equipment necessary to manufacture the server. The project would require net working capital at the beginning of each year in an amount equal to 11% of the next year's projected sales; for example, NWC = 11%4Salesı). The servers would sell for $25,000 per unit, and Webmasters believes that variable costs would amount to $18,000 per unit. After Year 1, the sales price and variable costs will increase at the inflation rate of 2%. The company's non-variable (fixed) costs would be $1.2 million at Year 1 and would also increase annually with inflation. The server project would have a life of 4 years. If the project is undertaken, it must be continued for the entire 4 years. The firm believes it could sell 1,200 units per year. The equipment would be depreciated over a 5-year MACRS depreciation schedule. The estimated market value of the equipment at the end of the project's 4-year life is $550,000. Webmasters' federal- plus-state tax rate is 21%. Its cost of capital is 9% for average-risk projects. Low-risk projects are evaluated with a WACC of 8%, and high-risk projects at 10%. 1. Should the firm invest in this project if the cash flows are uncertain (high risk)? 2. What is the maximum WACC that would permit investment in the project? 3. Are there additional potential value drivers missing from the analysis that could change the investment decision (consider MVA and the variables that drive value)? Steps for capital budgeting 1. Estimate project operating profitability (EBIT) 2. Subtract any opportunity costs or cannibalized sales 3. Estimate taxes 4. Add back depreciation (which is not a cash flow) to find operating cash flow 5. Calculate tax on any salvage value at the end of the project 6. Calculate changes in net operating working capital over the life of the project 7. Calculate initial investments required (invoice, delivery, installation, etc.) 8. Find free cash flow for each year of the project 9. Evaluate economic profitability and return (NPV, IRR, MIRR, Discounted Payback, etc.) 10. Answer the three questions regarding the project listed above.

Answer 1

Sales Price at Year 1 = $25,000 / Unit

Variable Cost at Year 1 = $18,000 / Unit

Fixed Cost at Year 1 = $1.2 million

It will increase by 2% each year, because of inflation.

So, Sales Price will be,

Year 1 = $25,000

Year 2 = 1.02 * 25000 = $25,500

Year 3 = 1.02 * $25,500 = $26,010

Year 4 = 1.02 * $26,010 = $26,530

Variable cost will be,

Year 1 = $18,000

Year 2 = 1.02 * 18000 = $18,360

Year 3 = 1.02 * $18,360 = $18,727

Year 4 = 1.02 * $18,727 = $19,102

Fixed Cost will be,

Year 1 = $1,200,000

Year 2 = $1,200,000 * 1.02 = $1,224,000

Year 3 = $1,224,000 * 1.02 = $1,248,480

Year 4 = $1,248,480 * 1.02 = $1,273,450  

Firm believes they will sell 1200 units / year.

Projected Sales,

Year 1= 1200 * Sales Price at Year 1 = 1200 * $25000 = $30,000,000

Year 2 = 1200 * Sales Price at Year 2= 1200 * $25,500 = $30,600,000

Year 3 = 1200 * Sales Price at Year 3 = 1200 * $26,010 = $31,212,000

Year 4 = 1200 * Sales Price at Year 4 = 1200 * $26,530 = $31,836,240

Company Needs Working Capital at each year's beginning, valued 11% of next year's sales.

So, Working Capital of Year by Year,

WC at Year 0 = 0.11 * Year 1 Sales = 0.11 * $30,000,000 = $3,300,000

WC at Year 1 = 0.11 * Year 2 Sales = 0.11 * $30,600,000 = $3,366,000

WC at Year 2 = 0.11 * Year 3 Sales = 0.11 * $31,212,000 = $3,433,320

WC at Year 3 = 0.11 * Year 4 Sales = 0.11 * $31,836,240 = $3,501,986

....................................................

- > Gross Profit Per Year = (Unit Sales Price - Unit Cost) * Unit Sold - Fixed Cost

Profit at Year 1 = (25,000 - 18,000) * 1200 - 1,200,000 = $7,200,000

Profit at Year 2 = (25,500 - 18,360) * 1200 - 1,224,000 = $7,344,000

Profit at Year 3 = (26,010 - 18,727) * 1200 - 1,248,480 =$7,491,120

Profit at Year 4 = (26,530 - 19,102) * 1200 - 1,273,450 = $7,640,150

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Market Value of the server after 4 years = $550,000

Tax rate = 21%

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Tax Expenses year on year will be,

Tax expense at year 1 = 0.21 * Profit at Year 1 = 0.21 * $7,200,000 = $1,512,000

Tax expense at year 2 = 0.21 * Profit at Year 2 = 0.21 * $7,344,000 = $1,542,240

Tax expense at year 3 = 0.21 * Profit at Year 3 = 0.21 * $7,491,120 = $1,573,135

Tax expense at year 4 = 0.21 * Profit at Year 4 = 0.21 * $7,640,150 = $1,604,432

Net Profit is Gross Profit minus Tax Expenses,

Net Profit at Year 1 = Profit at Y1 - Tax at Y1 = $7,200,000 - $1,512,000 = $5,688,000

Net Profit at Year 2 = Profit at Y2 - Tax at Y2 = $7,344,000 - $1,542,240 = $5,801,760

Net Profit at Year 3 = Profit at Y3 - Tax at Y3 = $7,491,120 - $1,573,135 = $5,917,985

Net Profit at Year 4 = Profit at Y4 - Tax at Y4 = $7,640,150 - $1,604,432 = $6,035,718

Covi Inflowendh ontflow Mortpmo 986 108- 0009%'8--pp GM) -3,300,000 +6,035,718 (Net fraft t) - 3,433,320 (wej 0१+10%9+ 5,917986 (tfacPIN) (Net erofit) 000 889 t 000'00871- (+,322,000) 3,36,A)1,A16,) (+6,035, 718)

[*** Please add $550,000 at 4th year. They will get that by selling the product. Forgot to write in the pic. So, at 4th-year cash inflow value will be $6,585,718]

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1) Now, we need to calculate NPV at 10% cost of capital (because of high risk).

NPV at 10% WACC = -1,918,392.66

NPV is negative so they should not invest in the project.

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2) Maximum WACC that would permit to invest in this project is,

WACC at which NPV = 0,

You can calculate using trial and error that at WACC = 3.71%, NPV = 0 (almost)

So, Maximum WACC = 3.71%

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3) Here we didn't take marketing cost. Because we know that to continuously sell 1200 units/year, it will take a good amount of marketing cost to make the sales easy out of the competition.  

...... Have a Good Day ................