Question

A company is considering a three-year project. New equipment will cost $200,000. The equipment falls in the MACRS three-year class (.3333, .4445, .1481, .0741) it will have a salvage value at the end of the Project of $50,000. The project is expected to produce sales of $100,000 in the first year and sales will increase by $50,000 each year after that. Expenses are expected to be 40% of sales. An investment in net-working capital of $5000 is required at the beginning of the project. In year 2, net working capital must be increased by $10,000. All net-working capital will be recovered in the final year. The tax rate is 30%. The company is funded with 40% debt with a yield of 7% and 60% equity with a required return of 15%.

A. What are the annual depreciation expenses and the after-tax salvage value of the machine?

B. What is the OCF for each of the three years?

C. What are the total cash flows for years 0-3?

D. What is the company's hurdle rate?

E. What is the NPV? IRR? Profitability Index? Show work.

F. Should the company invest in the project?

Answer 1

Part-A:

Depreciation Calculation:

Year	Cost of Equipment	Depn Rate	Depreciation	Closing Book Value
1	200,000	0.3333	66660	133,340
2	200,000	0.4445	88900	44,440
3	200,000	0.1481	29620	14,820

Book Value of Equipment at the end of project (i.e. at the end of year-3) = $14,820

Salvage value of Equipment at the end of project (i.e. at the end of year-3) = $50,000

Profit on sale of equipment = 50,000 – 14,820 = $35,180

Tax on profit on sale of equipment = 35180*30% = $10,554

After tax salvage value of the machine = 35180-10554 = $24,626.

.

.

.

Part-B:

Operating Cash Flows:

Year	Sales (1)	Expenses (2) = (1)*40%	Depreciation (3)	Operating profit (4) = (1)-(2)-(3)	Tax@30% (5) = (4)*30%	Operating profit after tax (6) = (4) - (5)	Operating Cash Flows (7) = (6) + (3)
1	100,000	40,000	66,660	(6,660)	(1,998)	(4,662)	61,998
2	150,000	60,000	88,900	1,100	330	770	89,670
3	200,000	80,000	29,620	90,380	27,114	63,266	92,886

.

Part-C:

Total Cash Flows:

Year	Iniial Investment (1)	Operating CashFlows(Calculated in part-b) (2)	Net Working Capital (3)	Salvage Value (4)	Total Cash Flows (5) = (1)+(2)+(3)+(4)
0	-200000	0	-5000	0	-205000
1	0	61998	0	0	61998
2	0	89670	-10000	0	79670
3	0	92886	15000	24626	132512

.

Part-D:

Company's Hurdle Rate (i.e. Weighted Average Cost of Capital):

After tax cost of Debt = 7%*0.30 = 4.90%

Particulars	Cost	Ratio/Weight	WACC/Hurdle rate = (Cost*Ratio/Weight)
Equity	15%	0.6	9.00%
Debt	4.90%	0.4	1.96%
		WACC/Hurdle rate	10.96%

.

Part-E:

Calculation of NPV:

Year	Total Cash Flows (Calculated from part-C)	DF Working	Discounting Factor @ 10.96%	Present Value (TCF*DF)
0	(205,000)	1	1	(205,000.00)
1	61,998	1/1.1096^1	0.901225667	55,874.19
2	79,670	1/1.1096^2	0.812207703	64,708.59
3	132,512	1/1.1096^3	0.731982429	96,996.46
			NPV	12,579.23

.

IRR Calculation:

At IRR,

Present Value of Cash Out Flows = Present Value of Cash Inflows

205,000 = 61998/(1+IRR)^1 + 79670/(1+IRR)^2 + 132512/(1+IRR)^3

Computing for IRR,

we get IRR = 14.03%

.

Therefore, IRR of the project = 14.03%

.

.

Profitability Index (PI) = Present Value of Cash Inflows/Initial Investment

PI = (55874.19+64708.59+96996.46)/205000

PI = 217,579.23/205,000

PI = 1.06

.

.

Part-F:

Yes , the company should invest in the project since :

1)NPV is positive

2)IRR of he project is greater than the hurdle rate of the company (14.03%>10.96%)

3)PI of the project is greater than 1.