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. Expense are expected to be 40% of sales. An investment in net-working capital of $5,000 is required at the beginning of the project. In year 2, net working captial must be increased by $10,000. All net-working capital will be recovered in the final year of the project. 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? (ATSV)

B. What is the Operating Cash Flow 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, and Profitability Index? Show work please.

F. Should the company invest in this project and why?

Answer 1

a). Annual depreciation expenses are:

Formula	Year (n)	1	2	3	4
	Asset cost	200000	200000	200000	200000
	%age depreciation	33.33%	44.45%	14.81%	7.41%
Asset cost*%age dep.	Depreciation expense (D)	66660	88900	29620	14820

After-tax salvage value = salvage value - tax rate*(salvage value - book value)

= 50,000 - 30%*(50,000 - 14,820) = 39,446

d). Hurdle rate for the company (or WACC) = (weight of debt*cost of debt*(1-Tax rate)) + (weight of equity*cost of equity)

= (40%*7%*(1-30%)) + (60%*15%) = 10.96%

Answers	Formula	Year (n)	0	1	2	3
		Initial investment (II)	200000
	Sn-1 + 50,000	Sales (S)		100000	150000	200000
	40%*S	Expenses (E)		40000	60000	80000
		Depreciation (D)		66660	88900	29620
	S-E-D	EBIT		-6660	1100	90380
	30%*EBIT	Tax @ 30%		-1998	330	27114
	EBIT-Tax	Net income (NI)		-4662	770	63266
		Add: Depreciation (D)		66660	88900	29620
Part (b)	NI+D	Operating Cash Flow (OCF)		61998	89670	92886
		Less: Inc. in NWC	-5000	0	-10000	15000
		Add: After-tax salvage value (ASV)				39446
Part (c)	OCF - Inc. in NWC + ASV - II	Free Cash Flow (FCF)	-205000	61998	79670	147332
	1/(1+10.96%)^n	Discount factor @ 10.96%	1.000	0.901	0.812	0.732
	FCF*Discount factor	PV of FCF	-205000.00	55874.19	64708.59	107844.44
Part (e)	Sum of all PVs	NPV	23427.21
Part (e)	Using IRR function with FCFs	IRR	16.53%
Part (e)	Sum of PV of all cash inflows/initial cash outflow	Profitability index (PI)	1.11

f). The company should invest in this project because it has a positive NPV and its IRR is greater than the company's hurdle rate.