Question

1. (25 points) Calder Inc. is considering a four-year project to manufacture military drones. This project requires an initial investment of $10 million that will be depreciated straight-line to zero over the project's life. An initial investment in the Net Working Capital of $1.3 million is required to support spare parts inventory; this cost is fully recoverable whenever the project ends. The company believes it can generate $7.35 million in pretax revenues with $2.4 million in total pre-tax operating costs. The tax rate is 38% and the discount rate is 16%. If you end the project prematurely, you can sell the equipment and recover some of your initial investment. The market value of the equipment over the life of the project changes as follows: Year Market Value ($million) 6.8 2 6.2 3.8 a) Assuming Calder operates this project for four years, what is the NPV? b) If the project is abandoned after 2 years, what is the NPV? If the project is abandoned after 3 years, what is the NPV?

Answer 1

	$ in Millions
Revenues	7.35
Less: Operating Costs	2.4
Less: Depreciation	2.5
Profit Before Tax	2.45
Less: Tax @38% [Profit Before Tax*0.38]	0.931
Profit After Tax	1.519
Add: Depreciation	2.5
Cash Flow	4.019

Depreciation as per SLM = (Cost-Salvage Value)/Useful Life = (10-0)/4 = 2.5 Millions

Cash Flow in Year 1 = Initial Investment + Working Capital = -10-1.3 = -11.3 Millions

Cash Flow in Year 2(if abandoned after 2 years) = Cash Flow as above + Working Capital + Market Value at Year 2 = 4.019 + 1.3 + 6.2 = 11.519 Millions

Cash Flow in Year 3(if abandoned after 3 years) = Cash Flow as above + Working Capital + Market Value at Year 3  = 4.019 + 1.3 + 3.8 = 9.119 Millions

Cash Flow in Year 4(if NOT ABANDONED PREMATURELY) = Cash Flow as above + Working Capital + Market Value at Year 4 = 4.019 + 1.3 + 1 = 6.319 Millions

Year	Cash Flows	Discounting Factor [1/(1.16^year)]	PV of Cash Flows (cash flow*discounting factor)
0	-11.3	1	-11.3
1	4.019	0.862068966	3.464655172
2	4.019	0.743162901	2.9867717
3	4.019	0.640657674	2.57480319
4	6.319	0.552291098	3.489927448
		NPV = Sum of PVs	1.21615751

Year	Cash Flows	Discounting Factor [1/(1.16^year)]	PV of Cash Flows (cash flow*discounting factor)
0	-11.3	1	-11.3
1	4.019	0.862068966	3.464655172
2	11.519	0.743162901	8.56049346
		NPV = Sum of PVs	0.725148633

Year	Cash Flows	Discounting Factor [1/(1.16^year)]	PV of Cash Flows (cash flow*discounting factor)
0	-11.3	1	-11.3
1	4.019	0.862068966	3.464655172
2	4.019	0.743162901	2.9867717
3	9.119	0.640657674	5.842157325
		NPV = Sum of PVs	0.993584198

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