Question

d e vorm a traditional NPV analysis and a positive option value expands the firm's opportunities. Quantitative Problem: Sunshine Smoothies Company (SSC) manufactures and distributes smoothies. SSC is considering the development of a new line of high-protein energy smoothies. SSC's CFO has collected the following information regarding the proposed project, which is expected to last 3 years: • The project can be operated at the company's Charleston plant, which is currently vacant. • The project will require that the company spend $4.1 million today (t-0) to purchase additional equipment. For tax purposes the equipment will be depreciated on a straight-line basis over 5 years. Thus, the firm's annual depreciation expense is $4,100,000/5 - $820,000. The company plans to use the equipment for all 3 years of the project. At t-3 (which is the project's last year of operation), the equipment is expected to be sold for $1,500,000 before taxes. • The project will require an increase in net operating working capital of $230,000 atto. The cost of the working capital will be fully recovered at t = 3 (which is the project's last year of operation). • Expected high-protein energy smoothie sales are as follows: Year Sales 1 $2,200,000 27,750,000 3 3,500,000 • The project's annual operating costs (excluding depreciation) are expected to be 60% of sales. • The company's tax rate is 40% • The company is extremely profitable; so if any losses are incurred from the high-protein energy smoothie project they can be used to partially offset taxes paid on the company's other projects. (That is, assume that if there are any tax credits related to this project they can be used in the year they occur.) • The project has a WACC - 10.0%. What is the project's expected NPV and IRR? Round your answers to 2 decimal places. Do not round your intermediate calculations. NPV $ IRR

Answer 1

Operating cash flow (OCF) each year = income after tax + depreciation

In year 3, the entire working capital investment is recovered.

loss on sale of equipment at end of year 3 = book value - salvage value.

book value = original cost - accumulated depreciation

after-tax salvage value = salvage value + tax benefit on loss on sale of equipment (the loss is tax deductible, and hence reduces the tax outgo. This is treated as a cash inflow)

NPV and IRR are calculated using NPV and IRR functions in Excel

NPV is $351,487.60.

IRR is 13.35%

A C D E 2 Initial Investment 3 Cost of equipment 4 Increase in net working capital $4,100,000 $730,000 6 OCF $2,200,000 $7,750,000 $3,500,000 $1,320,000 $4,650,000 $2,100,000 $820,000 $60,000 $2,280,000 $912,000 $36,000 $1,368,000 S820,000 $856,000 $2,188,000 $1,168,000 7 Revenues - Costs $820,000 $580,000 $232,000 $348,000 $820,000 - Depreciation $820,000 10 Earnings before tax $24,000 11Taxes 12 Income after tax 13Depreciation 14 OCF $820,000 15 16 Terminal Cash Flow $1,500,000 17 Salvage Value 18 Accumulated depreciation $2,460,000 $1,640,000 $140,000 $56,000 $1,556,000 $730,000 $2,286,000 19 Book value of equipment 20 Loss on sale of equipment 21 Tax benefit 22 Salvage Value after tax 23 Recovery of net working capital 24 Terminal Cash Flow 25 26 NPV Analysis 27 Project Cash Flows ($4,830,000) $856,000 $2,188,000 $3,454,000 28 S351,487.60 29 NPV 30 IRR 13.35%

A C E 2 Initial Investment 3 Cost of equipment 4100000 Increase in net working capital 730000 6 OCF 7 Revenues 2200000 7750000 3500000 -E7 60 % D7 60 % - Costs -C7 60 % 8 - Depreciation 820000 820000 820000 10 Earnings before tax -С7-С8-С9 -D7-D8-D9 -E7-E8-E9 D10 40 % -C10 40 % 11Taxes -E10 40% 12 Income after tax -C10-C11 -D10-D11 -E10- E11 13Depreciation -C9 D9 -E9 -D12 + D13 -E12+ E13 14 OCF C12+C13 15 16 Terminal Cash Flow 17 Salvage Value 18 Accumulated depreciation 1500000 -SUM(C9:E9) 19 Book value of equipment -B3-E18 20 Loss on sale of equipment -E19-E17 21 Tax benefit -E20 40% 22 Salvage Value after tax -E17+E21 23 Recovery of net working capital B4 24 Terminal Cash Flow -E22+E23 25 26 NPV Analysis 27 Project Cash Flows -E14 +E24 %3-В3-B4 -C14 =D14 28 -NPV(10 %,C27 : E27)+B27 29 NPV 30 IRR =IRR(B27:E27) 21