Question

TexMex Food Company is considering a new salsa whose data are shown below. The equipment to be used would be depreciated by the straight-line method over its 3-year life and would have a zero salvage value, and no new working capital would be required. Revenues and other operating costs are expected to be constant over the project's 3-year life.

However, this project would compete with other TexMex products and would reduce their pre-tax annual cash flows.

What is the project's NPV?

WACC 10.0%

Pre-tax cash flow reduction for other products (cannibalization) -$5,000

Investment cost (depreciable basis) $80,000

Straight-line deprec. rate 33.333%

Sales revenues, each year for 3 years $67,500

Annual operating costs (excl. deprec.) -$25,000

Tax rate 35.0%

Answer 1

Time line		0	1	2	3
Cost of new machine		-80000
=Initial Investment outlay		-80000
						100.00%
Sales			62500	62500	62500
Profits	Sales-variable cost		37500	37500	37500
-Depreciation	Cost of equipment/no. of years		-26666.6667	-26666.6667	-26666.6667	0	=Salvage Value
=Pretax cash flows			10833.33333	10833.33333	10833.33333
-taxes	=(Pretax cash flows)*(1-tax)		7041.666667	7041.666667	7041.666667
+Depreciation			26666.66667	26666.66667	26666.66667
=after tax operating cash flow			33708.33	33708.33	33708.33
+Tax shield on salvage book value	=Salvage value * tax rate				0
=Terminal year after tax cash flows					0
Total Cash flow for the period		-80000	33708.33	33708.33	33708.33
Discount factor=	(1+discount rate)^corresponding period	1	1.1	1.21	1.331
Discounted CF=	Cashflow/discount factor	-80000	30643.93636	27858.12397	25325.56724
NPV=	Sum of discounted CF=	3827.63