Question

NPV. Please help to solve and fill chart!

FINA 440 Net Present Value Angel Designs Angel Designs is a fashion clothing company that is considering investing in new machinery to improve its productivity over the next five years. A feasibility study was done for this project and cost $200,000. As a direct result of the new machinery, sales are expected to increase by $1,500,000 in the first year and increase by 4% per year after that. The marketing people at Angel hope that with new designs and the more advanced machinery, these sales increases could continue to grow at this rate for the foreseeable future. The CFO is more cautious, however. She thinks that the 4% growth is reasonable for the first 6 years, but that there is at least a 30% chance that circumstances would lead to this particular process to become totally obsolete by year seven. She has indicated that she believes that there is a 50% chance of growing for six years and then leveling off and continuing indefinitely, and a 20% chance of some growth beyond the six years. The new machinery costs $10 million and will be depreciated over 5 years on a straight line basis. The old machinery can be sold for $2 million and has no book value. The new machinery is more complicated, so will cost an additional $60,000 per year to maintain while other running costs will be reduced by $120,000 per year. Wages can also be reduced by $100,000 per year thanks to the increased automation Additional design costs are expected to be $30,000 per year, however, and are expected to rise at a rate of 5%. A one-time increase of $160,000 in net working capital is also expected in the first year of production The cost of Angel's debt is 12%. The company is closely held, and the CFO uses 18% as the required return for equity holders. The tax rate is 35%. Right now, the company has 40% debt, but the CFO would like to get that percentage up to at least 45% 1. (50 points) Complete the base case cash flow projections for 10 years on the attached form. Label specific line items clearly and identify any assumptions you are making. 2. (10 points) Calculate the WACC. 3. (10 points) Determine an appropriate terminal value for the project. Explain your assumptions 4. (5 points) Determine the net investment and the base case net present value. Would you recommend that Angel take on this project? Be complete in your explanation of your response. 5. (15 points) What risk analysis would you perform before coming to a final decision about this investment? Discuss the specific assumptions in the case that are particularly risky or ones that are critical to the outcome of the analysis. 6. (10 points) What specific modifications to the plan would you recommend that might increase the likelihood that the business would be a success?

Answer 1

Base Case-- Incremental sales by $ 1500000 & 4% increase Year-on-Year
Net Investment		St.line Depn.	10000000	Sale of old assets		Terminal value(TV)
Capitalised costs	-10000000	Base	20%	Selling price	2000000	TV(Last col.)	15541253
Time 0 expenses(NWC)	-160000	Yrs.	5	Book value	0	PV of TV	4415425
Tax effects	1300000	Annual amt.	2000000	Gain	2000000
Total Net Invetsment	-8860000			Tax effect	1300000
Free cash flows
Year	0	1	2	3	4	5	6	7	8	9	10	Terminal value at end yr.10
Revenues		1500000	1560000	1622400	1687296	1754787.84	1824979.35	1897978.53	1973897.67	2052853.58	2134967.72	2134968*1.04/(13.41%-4%)=	23595821
Incl.Maintenance costs		-60000	-60000	-60000	-60000	-60000	-60000	-60000	-60000	-60000	-60000	-60000/13.41%	-447427
Savings in running costs		120000	120000	120000	120000	120000	120000	120000	120000	120000	120000	120000/13.41%=	894855
Savings in wages		100000	100000	100000	100000	100000	100000	100000	100000	100000	100000	60000/13.41%	447427
Incl.design costs		-30000	-31500	-33075	-34728.75	-36465.19	-38288.45	-40202.87	-42213.01	-44323.66	-46539.85	-46539.8*1.05/(13.41%-5%)=	-581056
Depreciation		-2000000	-2000000	-2000000	-2000000	-2000000.00
=EBIT		-370000	-311500	-250675	-187432.75	-121677.35	1946690.91	2017775.66	2091684.66	2168529.91	2248427.87		23909619
-Taxes		129500	109025	87736.25	65601.463	42587.07	-681341.82	-706221.48	-732089.63	-758985.47	-786949.76		-8368367
+Depreciation		2000000	2000000	2000000	2000000	2000000	0	0	0	0	0		0
Opg.cash flows		1759500	1797525	1837061	1878169	1920910	1265349	1311554	1359595	1409544	1461478		15541253
Terminal Value(Ref.last col.)											15541253
Total Net Yr.0 Invetsment	-8860000
Free cash flows	-8860000	1759500	1797525	1837061	1878169	1920910	1265349	1311554	1359595	1409544	17002731
PV F at 13.41%(1/1.1341^Yr.n)	1	0.88176	0.77749	0.68556	0.60450	0.53302	0.46999	0.41442	0.36542	0.32221	0.28411
PV at 13.41%	-8860000	1551450	1397566	1259417	1135349	1023883	594706	543534	496820	454168	4830646
NPV	4427538

2. WACC=(Wt.d*kd)+Wt.e*ke)

ie.(45%*12%*(1-35%))+(55%*18%)=

13.41%

1..Base Case Considered is---- Incremental sales by $ 1500000 & 4% increase Year-on-Year

After Year 10, sales increase by 4% indefinitely,ie. G=4% ,hence PV of sales at end yr.10 is found using the formula for constant growth model , with the WACC=13.41%

All other incremental expenses/savings also occur in perpetuity . So, formula for PV of perpetuity, ie. CF/WACC% is used.

Design costs are treated the same way as sale with g=5%, indefinitely.

3. Terminal value calculations, taking item by item, are shown in the last 2 columns of the NPV analysis.

Since, it is treated as an indefinite project,NET WORKING CAPITAL RECOVERY IS CONSIDERED NIL VALUE.As time increases, time value of money is almost NEGLIGIBLE.

4. Net Investment= $ 8860000 (as tabulated in the beginning of the NPV analysis) & the base case NPV= $ 4427538.

Yes. The project is recommended , as the NPV (for the projected growth assumptions) is POSITIVE.

5.First thing will be , to be certain about the increase in revenues & savings in costs --to verify , if the projected numbers & % ages are most likely.Same need to done for expenses,if they are not likely to increase and catch one off-guard.Specific assumption that sales will increase forever into the future , is quite a risky one, considering that operating in a fashion industry, chances are very high, for one to get outdated very soon , due to competitors'products constantly flooding the market.

6.As the CEO is of different opinions about the probability of sales revenues increasing by the said 4%,it is suggested to run different scenario/s analysis , to be aware of the possible outcomes,so as to reduce risk.

Scenario/s analysis need to be done by varying all the components of revenues & incomes, their growth patterns, the depreciation rate of machinery, etc.