Question

United Pigpen is considering a proposal to manufacture high-protein hog feed. The project would require use of an existing warehouse, which is currently rented out to a neighboring firm. The next year’s rental charge on the warehouse is $145,000, and thereafter, the rent is expected to grow in line with inflation at 4% a year. In addition to using the warehouse, the proposal envisages an investment in plant and equipment of $1.47 million. This could be depreciated for tax purposes straight-line over 10 years. However, Pigpen expects to terminate the project at the end of 8 years and to resell the plant and equipment in year 8 for $490,000. Finally, the project requires an immediate investment in working capital of $395,000. Thereafter, working capital is forecasted to be 10% of sales in each of years 1 through 7. Working capital will be run down to zero in year 8 when the project shuts down. Year 1 sales of hog feed are expected to be $5.10 million, and thereafter, sales are forecasted to grow by 5% a year, slightly faster than the inflation rate. Manufacturing costs are expected to be 90% of sales, and profits are subject to tax at 25%. The cost of capital is 12%. What is the NPV of Pigpen’s project? (Do not round intermediate calculations. Enter your answer in dollars not in millions, rounded to the nearest whole dollars.)

Answer 1

Operating cash flow (OCF) each year = income after tax + depreciation - change in working capital.

In year 8, the entire working capital investment is recovered, and hence the change in working capital is negative

profit on sale of equipment at end of year 8 = sale price - book value.

book value = original cost - accumulated depreciation

after-tax salvage value = salvage value - tax on profit on sale of equipment.

  

NPV is calculated using NPV function in Excel

NPV is $707,441.

B28 =NPV(12%,C26:26) +B26 C D 12 E F G H I $1,470,000 2 Initial Investment 3 Cost of plant and equipment 4 5 OCF 6 Revenues 7 - Costs 8 - Depreciation 9 - loss of rent 10 Earnings before tax 11 - Taxes 12 Earnings after tax 13 Working capital required 14 Change in working capital 15 OCF $5,100,000 $4,590,000 $147,000 $14,500 $348,500 $87,125 $261,375 $510,000 $115,000 $293,375 $5,355,000 $5,622,750 $4,819,500 $5,060,475 $147,000 $147,000 $15,080 $15,683 $373,420 $399,592 $93,355 $99,898 $280,065 $299,694 $535,500 $562,275 $25,500 $26,775 $401,565 $419,919 $5,903,888 $6,199,082 $6,509,036 $6,834,488 $7,176,212 $5,313,499 $5,579,174 $5,858,132 $6,151,039 $6,458,591 $147,000 $147,000 $147,000 $147,000 $147,000 $16,311 $16,963 $17,641 $18,347 $19,081 $427,078 $455,945 $486,262 $518,102 $551,540 $106,770 $113,986 $121,566 $129,525 $137,885 $320,309 $341,959 $364,697 $388,576 $413,655 $590,389 $619,908 $650,904 $683,449 $28,114 $29,519 $30,995 $32,545 ($683,449) $439,195 $459,439 $480,701 $503,031 $1,244,104 $395,000 $395,000 ($395,000) 16 17 Terminal Cash Flow 18 Salvage Value 19 Accumulated depreciation 20 Book value of plant and equipement 21 Profit on sale of plant and equipement 22 Tax 23 Salvage Value after tax $490,000 $1,176,000 $294,000 $196,000 $49,000 $441,000 25 NPV Analysis 26 Project Cash Flows 27 28 NPV ($1,865,000) $293,375 $401,565 $419,919 $439,195 $459,439 $480,701 $503,031 $1,685,104 $707,441!

L29 5 2 Initial Investment 3 Cost of plant and equipment 1470000 5 OCF 6 Revenues 7 - Costs 8 - Depreciation 9 - loss of rent 10 Earnings before tax - Taxes Earnings after tax Working capital required Change in working capital 15 OCF 5100000 =C6*1.05 =D6*1.05 =E61.05 =F6*1.05 G6 1.05 =H61.05 =16*1.05 =C6*90% =D6*90% =E690% =F6.90% G6-90% H6.90% =16*90% =J6-90% =$B$3/10 -$B$3/10 =$B$3/10 =$B$3/10 -$B$3/10 =$B$3/10 =$B$3/10 =$B$3/10 14500 =C9*1.04 =D9*1.04 =E9*1.04 =F9*1.04 =G9*1.04 =H9 1.04 =19*1.04 =C6-C7-C8-C9 =D6-07-D8-D9 = E6-E7-E8-E9 =F6-F7-F8-F9 =G6-G7-G8-G9 =H6-H7-H8-H9 =16-17-18-19 = 16-17-18-19 =C10*25% =D10*25% =E10*25% =F10*25% =G10*25% =H10*25% -110*25% = 10*25% =C10-C11 =D10-011 =E10-E11 =F10-F11 =G10-G11 =H10-H11 =110-111 =)10-J11 =C6*10% =D6*10% =E6.10% =F6-10% =G6.10% =H6.10% =16.10% 0 =C13-B13 =D13-C13 =E13-D13 =F13-E13 G13-F13 =H13-G13 =113-H13 J13-113 =C12+C8-C14 =D12+D8-D14 =E12+E8-E14 =F12+F8-F14 =G12+G8-614 =H12+H8-H14 =112+18-114 = 12+8-J14 395000 =B13 =B12+B8-B14 17 Terminal Cash Flow 18 Salvage Value 19 Accumulated depreciation 20 Book value of plant and equipement 21 Profit on sale of plant and equipement 22 Tax 23 Salvage Value after tax 24 25 NPV Analysis 490000 =SUM(C8:18) =B3-119 =J18-J20 =)21.25% =J18-J22 --B3+B15 =C15 =D15 =E15 -F15 =G15 =115 = 15+23 27 28 NPV =NPV(12%,C26:26) +B26 20