Question

Company A is considering installing a new molding machine which is expected to produce operating cash flows of $73,000 a year for 7 years. At the beginning of the project, inventory will decrease by $16,000, accounts receivables will increase by $21,000, and accounts payable will increase by $15,000. All net working capital will be recovered at the end of the project. The initial cost of the molding machine is $249,000. The equipment will be depreciated straight-line to zero in book value over the life of the project. The equipment will be salvaged at the end of the project creating a $48,000 after-tax cash flow. At the end of the project, net working capital will return to its normal level. What is the net present value of this project given a required return of 14.5 percent?

Answer 1

This sum seems to be tricky because of the Working capital changes mentioned. However, keeping it simple - An increase in Current Assets (Inventory, Accounts Receivable) would lead to a decrease in cash (as cash is paid for these assets). Similarly, an increase in Current Liabilities would lead to an increase in cash (as cash is received, because it is a liability).

At time 0, the cash flow that occurs is shown below:

CF0 = -$249,000 + $16,000 - $21,000 + $15,000 = -$239,000

At time 7, the cash flow that occurs is shown below:

CF0 = $73,000 + $48,000 - $16,000 + $21,000 - $15,000 = $63,000

The question states that that net working capital would be recovered after the completion of the project. Thus, the reverse effect occurs.

To calculate NPV with a 14.5% rate, the formula is as follows:

NPV = -$239,000 + $73,000* {[1-(1/(1+0.145)^6)] / 0.145} + [$111,000/(1+0.145)^7]

This amounts to NPV = $84,049.74