Question

2. The following I/S is based on the information associated with a new project. Answer the questions. GOSIA 1000 oy obvoda bo Projected Income Statements Year Sales Variable Cost Fixed Cost Depreciation EBIT Taxes (40%) Net income 9,000,000 5,000,000 2,500,000 750,000 750,000 300,000 450,000 9,000,000 5,000,000 2,500,000 750,000 750,000 300,000 450,000 9,000,000 5,000,000 2,500,000 750,000 750,000 300,000 450,000 9,000,000 5,000,000 2,500,000 750,000 750,000 300,000 450,000 1) We plan to invest $3,000,000 to get started. The residual book value of the new equipment is zero at Year 4 and it will be sold for $300,000 at the end of the project. Moreover, we save $50,000 in the networking capital (NWC) at the beginning of the project. The tax rate is 40%. Fill out the projected cash flow table. (70 points) Projected Cash Flows Year ( ) ( ) ( Changes in NWC -3.000.000 Capital spending Total Cash Flow 1) Figure out the net present value (NPV) of this project if the required return is 20%. Based on the NPV, do you accept or reject this project? (30points)

Answer 1

Answer I:

Let us first calculate the operating cash flows from Year 1 to Year 4:

Year 1 $9,000,000 $9,000,000 $9,000,000$9,000,000 ($5,000,000) ($5,000,000) ($5,000,000) ($5,000,000) ($2,500,000) ($2,500, 000) ($2,500,000) ($2,500,000) ($750,000) ($750,000) $750,000 Sales Variable cost Fixed cost ($750,000) $750,000 ($750,000) $750,000 ($300,000) $450,000 Depreciation $750,000 ($300,000) ($300,000) EBIT ($300,000) $450,000 Taxes at 40% $450,000 $750,000 $1,200,000 $1,200,000$1,200,000 $1,200,000 $450,000 Net Income Add Back depreciation Operating Cash flow (OCF) $750,000 $750,000 $750,000

Year 4 salvage value net of tax = 300000 * (1 - 40%) = $180,000

Projected Cash flows are as below:

Year 1 2 4 $1,200,000 $1,200,000 $1,200,000 $1,200,000 OCF $50,000 ($50,000) Changes in NWc Capital spending ($3,000,000) ($2,950,000) $180,000 $1,200,000 $1,200,000 $1,200,000$1,330,000 Total cash flow

Answer II:

NPV = $219,174.38

Since NPV is positive, project should be accepted.

Working:

Year 3 4 $1,200,000 $1,200,000 $1,200,000 $1,200,000 OCF ($50,000) $50,000 Changes in NWC ($3,000,000) $180,000 $1,330,000 Capital spending $1,200,000 $1,200,000 ($2,950,000) $1,200,000 Total cash flow PV factor (1/(1+20%) ^Year) 0.83333 0.69444 0.57870 0.48225 ($2,950,000.00) $1,000,000.00 $833,333.33 $694,444.44 $641,396.60 PV of cash flows $219,174.38 NPV