Question

(1) A firm is considering an expansion project that will last three years. The project requires an immediate purchase of a new equipment that costs $900,000. The equipment will be fully depreciated using straight-line method over the next three years. The resale price of the equipment at the end of year three is estimated to be $200,000. The project will generate annual sales of $750,000 and incur annual costs (all costs except depreciation expense) of $200,000 for each of the next three years. The project requires an immediate investment of $50,000 in NWC, which will be fully recovered in year 3. The corporate tax rate is 30%. Calculate the Cash Flow from Assets (Project Cash Flow) for the project for years 0, 1, 2, and 3. (2) For the project above in question (1), calculate the payback period, the discounted payback period, the net present value, and the internal rate of return. Assume that the required rate of return is 15%. Consider the following two projects A and B. Assume that the appropriate discount rate for each project is 20%. Year CF for Project A CF for Project B - $1,700 900 1 2 3 - $100 70 80 90 900 900 (3) If projects A and B are independent projects, which project(s) should you accept based on your best capital budgeting criteria? Please explain your rationale. (4) If projects A and B are mutually exclusive projects, which project(s) should you accept based on your best capital budgeting criteria? Please explain your rationale.

Answer 1

1). Project cash flows: Year 0 = -950,000; Year 1 = 475,000; Year 2 = 475,000; Year 3 = 665,000

2). NPV = 259,460.01; IRR = 29.94%

All calculations in the table below:

Year (n) Formula 0 2 Initial Investment (I) Annual sales (S) Annual cost ('C) Depreciation (D) 900000 750000 750000 750000 200000 200000 200000 1I/3 300000 300000 300000 |ЕBIT 250000 250000 S-C-D 250000 Tax @ 30% 30%*EBIT 75000 75000 75000 Unlevered net income (NI) EBIT-Тax 175000 175000 175000 Add: Depreciation (D) Operating Cash Flow (OCF) Less: Increase in NWC Add: After-tax salvage value (ASV) Project Cash Flow (PCF) 300000 300000 300000 475000 475000 475000 -50000 50000 Salvage value*(1-Tax rate) 140000 -950000 475000 475000 665000 1/(1+15 % )An PCF Discount factor Discount factor @15% 1.000 0.756 0.870 0.658 PV of PCF 950000 413043.48 359168.242 437248.29 Sum of all PVs NPV 259460.01 Using IRR function with PCFS IRR 29.94%

Payback period = 2 years; discounted payback period = 2.41 years

Year (n) Formula 0 1 2 Project Cash Flow (PCF) Cumulative cash flow (CCF) Payback period (in years) 475000 475000 -950000 665000 -950000 -475000 PCFn CCFn-1 665000 (-CCF1/PCF2) +2 2.00

Year (n) Formula 0 1 2 Discounted PCF (DPCF) Cumulative cash flow (CCF) 950000 413043.48 -950000536956.5 359168.242 437248.29 DPCFnCCFn-1 -177788.28 259460.01 Discounted payback period (in years) (-CCF2/DPCF3) 2 2.41

3).

Year (n) Formula 0 1 2 Project A cash flow (CF -100 70 80 90 Project B cash flow (CFn) -1700 900 900 900 Using NPV function with CFA Project A NPV Using NPV function with CF Project B NPV Using IRR function with CFA Project A IRR 54.98 163.19 57.26% Using IRR function with CFB Project B IRR 27.24%

As per the NPV rule, project B should be selected but as per the IRR rule, project A should be selected. Usually, the NPV decision is taken as NPV is considered a better metric of project earnings. However, if both projects are independent then both can be selected.

4). If the projects are mutually exclusive then only one of the two can be selected. In this case, it is better to go by the NPV rule and select project B.