Question

WinterWorld Productions is assessing a capital investment. The investment will entail a new machine costing $260,000 with $10,000 of NWC needed to start. If they do not go forward with this project they can rent out the space for $50,000. The machine can be sold at the end of the 5 year project for $60,000. MACRS 5 year will be used. The expected annual unit sales are 3,000/5,000/6,000/4,000/2,000. Selling price is $50 with an increase of 5% per year after year 1. Operating costs are $32 with an increase of 5% per year after year 1. The financial analyst for this project is new and risk-averse and will use 9% for the WACC rather than their actual cost of capital.

3. Using NPV and IRR analysis, should they proceed with the project?

Answer 1

Below is the calculation of NPV and IRR for the project:

A В C D E F Н K Operating Profit (Selling Depreciation (Initial Investment Selling Price Price-Cost per unit)*Unit of Before Tax cash flow (Operating Profit+salvage Present Value of cash flow Cost per unit (Cash flow/(1+9%)^year) (270,000.00) value-initial investment-MWC) Year Initial Investment NWC Depreciation Rate Dereciation Rate) Salvage Value Units of Sales (5% increment every year) (5% increment every year) sales (270,000.00) 54,000.00 (260,000.00) (10,000.00) 0 0 20% 50.00 1 52,000.00 3,000.00 32.00 54,000.00 49,541.28 32% 2 83,200.00 5,000.00 52.50 33.60 94,500.00 94,500.00 79,538.76 19.20% 49,920.00 6,000.00 55.13 35.28 119,070.00 119,070.00 91,943.89 11.52% 83,349.00 29,952.00 4,000.00 57.88 37.04 83,349.00 59,046.53 11.52% 29,952.00 38.90 43,758.23 103,758.23 5 60,000.00 2,000.00 60.78 67,435.73 Total (NPV) -SUM(L2:L7) 18.67% IRR

A В C E G Н K Operating Profit (Selling Depreciation (Initial Investment Selling Price Price-Cost per unit) Unit of Before Tax cash flow (Operating Profit+salvage Present Value of cash flow Cost per unit (Cash flow/(1+9%) ^year) Initial Investment NWC value-initial investment-MwC) Depreciation Rate Dereciation Rate) Salvage Value Units of Sales (5% increment every year) (5% increment every year) sales Year (270,000.00) (270,000.00) (260,000.00) (10,000.00) 0 0 20% 52,000.00 3,000.00 1 50.00 32.00 54,000.00 54,000.00 49,541.28 32% 83,200.00 2 5,000.00 52.50 33.60 94,500.00 94,500.00 79,538.76 19.20% 6,000.00 119,070.00 3 49,920.00 55.13 35.28 119,070.00 91,943.89 11.52% 4,000.00 57.88 59,046.53 4 29,952.00 37.04 83,349.00 83,349.00 29,952.00 60.78 43,758.23 103,758.23 5 11.52% 60,000.00 2,000.00 38.90 67,435.73 Total (NPV) 77,506.19 |=IRR(K2:K7) IRR(values, [guess]) IRR

Here NPV is $77506.19 which is more than the Rent of $50000 and the IRR is also greater than the WACC.

Hence, they should go ahead with the project as per the before tax cash flow (As tax rate is not given in the question).