Question

You are considering a 4-year project to start a new line of men’s clothing. Fashion trends change quickly, so you think that by the end of the 4th year, the clothing line will be worthless. You will need to invest $2,000,000 up front in capital expenditures, and you will need a $250,000 investment in net working capital, which will be returned at the end of the project. You expect to sell each item for $275 and plan to sell 5,000 items each year. Your variable costs are $91 per item and you will have fixed costs of $500,000 per year. You will depreciate your capital expenditures using straight line depreciation. If your tax rate is 21% and the cost of capital is 12%, should you invest in this project?

Answer 1

Depreciation = Cost of the Project / Useful life years = $2,000,000 / 4 = $500,000

Cash flow at year 0 = Cost of Project + Investment in NWC = $2,000,000 + $250,000 = $2,250,000

Annual Cash Flow(Year 1 - 4) = [{(P - VC) * Qty. Sold} - Fixed Cost] * [1 - t] + [Depreciation * t]

= [{($275 - $91) * 5,000} - $500,000] * [1 - 0.21] + [$500,000 * 0.21]

= $331,800 + $105,000 = $436,800

Additional Cash Flow at year 4 = Recovery of NWC = $250,000

NPV = PV of Cash Inflows - PV of Cash Outflows

= [$436,800 * {1 - (1 + 0.12)^-4} / 0.12] + [$250,000 / (1 + 0.12)⁴] - $2,250,000

= [$436,800 * 3.0373] + [$250,000 / 1.5735] - $2,250,000

= $1,326,714.20 + $158,879.52 - $2,250,000 = -$764,406.29

No. you shouldn't invest in this project as the NPV is negative.