Question

Financial Management Name: i. The Movie Place is considering a new investment whose data are shown below. The required equipment has a 3-year tax life and would be fully depreciated by the straight line method over the 3 years, but it would have a positive salvage value at the end of Year 3, when the project would be closed down Also, some new working capital would be required, but it would be recovered at the end of the projects life. Revenues and other operating costs are expected to be constant over the project's 3-year life. What is the project's NPV? WACC 10% Net equipment cost (depreciable basis) Required new working capital Straight line depr'n rate Sales revenues Operating costs excl. depr'n Expected pretax salvage value Tax rate $65,000 $10,000 33.33% $70,000 $25,000 $5,000 35 % Year Yr 1 Yr 0 Yr 2 Yr3 Capital Spending Net Working Capital Operating Cash Flows Yr 1 Yr 2 Yr 0 Yr3 Total Cash Flows NPV

Answer 1

operating cash flow (OCF) each year = earnings after tax + depreciation.

The equipment is fully depreciated by end of Year 3, hence its book value is zero. As the book value is zero, the entire salvage value is subject to tax because the entire salvage value is a profit on sale of equipment.

NPV is calculated using NPV function in Excel.

NPV is $21,483

B26 fx =NPV(10%,C24:E24) +B24 IDE 1 2 2 Initial Investment 3 Cost of equipment 4 Investment in working capital $65,000 $10,000 $70,000 $25,000 $21,667 $23,333 $8,167 $15,167 $21,667 $36,833 $70,000 $25,000 $21,667 $23,333 $8,167 $15,167 $21,667 $36,833 $70,000 $25,000 $21,667 $23,333 $8,167 $15,167 $21,667 $36,833 6 OCE 7 Revenues 8 - Operating costs 9 - Depreciation 10 Earnings before tax 11 - Taxes 12 Earnings after tax 13 + Depreciation 14 OCF 15 16 Terminal Cash Flow 17 Salvage Value 18 Tax 19 Salvage Value after tax 20 Recovery of working capital 21 Terminal Cash Flow 22 23 NPV Analysis 24 Project Cash Flows 25 26 NPV $5,000 $1,750 $3,250 $10,000 $6,500 ($ 75,000) $36,833 $36,833 $43,333 $21,483

B E 1 2 3 А 1 2 Initial Investment 3 Cost of equipment 4 Investment in working capital 65000 10000 5 70000 25000 =$B$3/3 =C7-C8-C9 =C10*35% =C10-C11 =C9 =C12+C13 70000 25000 =$B$3/3 =D7-D8-D9 =D10*35% =D10-011 =D9 =D12+D13 70000 25000 =$B$3/3 =E7-E8-E9 =E10*35% =E10-E11 E9 =E12+E13 6 OCF 7 Revenues 8 - Operating Costs 9 - Depreciation 10 Earnings before tax 11 - Taxes 12 Earnings after tax 13 + Depreciation 14 OCF 15 16 Terminal Cash Flow 17 Salvage Value 18 Tax 19 Salvage Value after tax 20 Recovery of working capital 21 Terminal Cash Flow 22 23 NPV Analysis 24 Project Cash Flows 25 26 NPV 5000 =E17*35% =E17-E18 =B4 =E19+E19 --B3-B4 =C14 =114 =E14+E21 =NPV(10%,C24:E24)+B24