Question

The company Smart Inc. is a company that makes Dog Shampoo in Sudbury area. The results have been presented in the financial statement.

Sales 16 000 000$

Fixed Costs (8 000 000)

Variable Costs (12 000 000)

Depreciation (3 000 000)

Profit (loss) (7 000 000)

According to the experts, this loss has been caused by the poor performance of the equipment. They suggest to the board of directors to replace the old equipment by new ones. Considering following information, the board of directors asks you to evaluate this project for the company.

• The new equipment would allow the company to avoid this loss entirely and generate a profit of 2.5 million dollars per year. The purchase and installation of the new equipment require an initial investment of 21 000 000$. The old equipment can be sold at the beginning of project on the market for 2 000 000$ (This amount is considered as an exchange value). The new equipment has a salvage value of 3 million dollars in 10 years (End of the project).

• The project also requires an additional investment in heavy equipment for the total amount of 4 000 000$ at the end of 5^th year.

• The project also requires an additional investment in new Computers and furniture for a total amount of 800 000$ in the beginning of project. Computers and furniture have to be replaced by new ones after 5 years for the same amount. The do not have any residual value.

• The company will need to invest also an additional amount of 1200 000$ in new inventory at the beginning of project. The amounts of inventory will return to zero at the end of the project.

• At the present time, Smart Inc is renting a warehouse for the annual rent of 50 000$ (paid at the end of year). If the company undertakes the new project, they will need a larger warehouse for the annual rent of 200 000$ (to be paid annually at the End of each year).

• The project also requires 8 new technicians today with annual salary of 60 000$ for each. Given the performance of new equipment, Smart Inc could lay off 100 employees whose annual salaries is 30 000$. The lay off will oblige the company to pay lay off premiums in the amount of 8000$ to each employee which will be tax deductible.

The corporate tax rate is at 40%. The new equipment is in the category with a depreciation of 20%, calculated with decreasing (declining) method. The computers and furniture are depreciated by linear method at 10%. Investors require 12% on this type of project. Given this information, answer the following questions:

1. Identify and calculate the present value of all cash flows at the beginning of project.

2. Identify and calculate the present value of each periodical cash flow (after taxes) during the project.

3. Identify and calculate the present value of all cash flows at the end of the project.

4. Calculate the Net Present Value of this project.

5. Calculate the maximum price that Smart Inc can afford to invest in the new equipment at the beginning of project in order to keep the project profitable. (That means the additional investment in heavy equipment at the end of 5^th year and all other items in the initial investment remain the same).

6. Calculate the Operational Cash Flow (OCF) of the 3^rd year of this project.

Answer 1

I will provide the answer to the Net Present Value in a table. In this way, you could appreciate the cash flows per period:

	PERIOD
	0	1	2	3	4	5	6	7	8	9	10
CASH INFLOWS
Sale of old equipment	$           2,000,000
Annual savings on salaries		$          3,000,000	$          3,000,000	$          3,000,000	$          3,000,000	$          3,000,000	$          3,000,000	$          3,000,000	$          3,000,000	$          3,000,000	$          3,000,000
Tax savings from layoff	$               320,000
Annual inflow		$          2,500,000	$          2,500,000	$          2,500,000	$          2,500,000	$          2,500,000	$          2,500,000	$          2,500,000	$          2,500,000	$          2,500,000	$          2,500,000
Salvage value of equipment											$          3,000,000
Total inflow per period	$           2,320,000	$          5,500,000	$          5,500,000	$          5,500,000	$          5,500,000	$          5,500,000	$          5,500,000	$          5,500,000	$          5,500,000	$          5,500,000	$          8,500,000
CASH OUTFLOWS
Initial Investment	-$         21,000,000
Heavy equipment						-$          4,000,000
New PC & furniture	-$              800,000
Replacement of PC & furniture						-$             800,000
Inventory	-$           1,200,000
Annual rent		-$             200,000	-$             200,000	-$             200,000	-$             200,000	-$             200,000	-$             200,000	-$             200,000	-$             200,000	-$             200,000	-$             200,000
New technicians		-$             480,000	-$             480,000	-$             480,000	-$             480,000	-$             480,000	-$             480,000	-$             480,000	-$             480,000	-$             480,000	-$             480,000
Lay off premiums	-$              800,000
Depreciation of New equipment (20%)		-$          4,200,000	-$          3,360,000	-$          2,688,000	-$          2,150,400	-$          1,720,320	-$          1,376,256	-$          1,101,005	-$             880,804	-$             523,215	$                         -
Depreciation of Heavy equipment (20%)							-$             800,000	-$             640,000	-$             512,000	-$             409,600	-$             327,680
Depreciation of PC (10%)		-$                80,000	-$                80,000	-$                80,000	-$                80,000	-$                80,000	-$                80,000	-$                80,000	-$                80,000	-$                80,000	-$                80,000
Total outflow per period	-$         23,800,000	-$          4,960,000	-$          4,120,000	-$          3,448,000	-$          2,910,400	-$          7,280,320	-$          2,936,256	-$          2,501,005	-$          2,152,804	-$          1,692,815	-$          1,087,680
Initial balance	-$         21,480,000
Annual cash balance before taxes		$              540,000	$          1,380,000	$          2,052,000	$          2,589,600	-$          1,780,320	$          2,563,744	$          2,998,995	$          3,347,196	$          3,807,185	$          7,412,320
Net cash flow per period		$         324,000	$         828,000	$       1,231,200	$       1,553,760	-$       1,068,192	$       1,538,246	$       1,799,397	$       2,008,318	$       2,284,311	$       4,447,392
Net cash flow per period +depreciation		$       4,604,000	$       4,268,000	$       3,999,200	$       3,784,160	$         732,128	$       3,794,502	$       3,620,402	$       3,481,122	$       3,297,126	$       4,855,072
discount rate	12%
NPV of the cash flows	$         20,898,266	$       4,110,714	$       3,402,423	$       2,846,552	$       2,404,902	$         415,429	$       1,922,413	$       1,637,686	$       1,405,967	$       1,188,977	$       1,563,203
NPV of the project	-$      581,734

To arrive to the final number you need to determine:

• initial net investment
• net cash flow per period

Then, you discount each CF (cash flow) with the rate of 12%. Remember to add the depreciation as it is not a "real expense". At the end, you have to substract the initial investment from the net present value of your CFs. The number is negative, so the project should be rejected.