Question

Arnold Inc. is considering a proposal to manufacture high-end protein bars used as food supplements by body builders. The project requires use of an existing warehouse, which the firm acquired three years ago for $1 million and which it currently rents out for $135,000. Rental rates are not expected to change going forward. In addition to using the warehouse, the project requires an upfront investment into machines and other equipment of $1.4 million. This investment can be fully depreciated straight-line over the next 10 years for tax purposes. However, Arnold Inc. expects to terminate the project at the end of eight years and to sell the machines and equipment for $444,000. Finally, the project requires an initial investment into net working capital equal to 10 percent of predicted first-year sales. Subsequently, net working capital is 10 percent of the predicted sales over the following year. Sales of protein bars are expected to be $4.7 million in the first year to stay constant for eight years. Total manufacturing costs and operating expenses (excluding depreciation) are 80 percent of sales, and profits are taxed at 30 percent. a. What are the free cash flows of the project? b. If the cost of capital is 15%, what is the NPV of the project? a. What are the free cash flows of the project? The FCF for year is $ million. (Round to three decimal places.) The FCF for years 1-7 is $ million. (Round to three decimal places.) The FCF for year 8 is $ million. (Round to three decimal places.) b. If the cost of capital is 15%, what is the NPV of the project? The NPV of the project is $ million (Round to three decimal places.)

Answer 1

Answers:

a)

FCF for year 0 = $1,870,000

FCF for year 1 to 7 = $605,500

FCF for year 8 = $1,470,300

b) NPV of project = $1,129,297.9

Explanation:

Computation of initial working capital requirement:

= 10% of predicted sales

= 10% of $4,700,000

= $470,000

Computation of FCF for year 0:

= Initial capital expenditure requirement + Initial working capital requirement

= $1,400,000 + $470,000

= $1,870,000

Computation of FCF for year 1 to 7:

Lost rent -135000
Sales revenue 4700000
Manufacturing costs -3760000
EBITDA 805000
Depreciation expense -140000
EBIT 665000
Tax expense at 30% -199500
Earnings after tax 465500
Add back of Depreciation 140000
Free cash flow 605500

Computation of tax on gain:

Original cost 1400000
Depreciation (8yrs x 140,000)   1120000
Book value 280000
Salvage value 444000
Gain 164000
Tax on gain (@30%) 49200

Computation of FCF for year 8:
Lost rent -135000
Sales revenue 4700000
Manufacturing costs -3760000
EBITDA 805000
Depreciation expense -140000
EBIT 665000
Tax expense at 30% -199500
Earnings after tax 465500
Add back of Depreciation    140000
Salvage value 444000
Tax on gain -49200
Working capital recovery 470000
Free cash flow 1470300

Computation of discounted FCF of year 1 to 7:

= Annual FCF x Present value annuity factor at 15% for 8 period line

= 605500 x 4.159627

= 2518654

Computation of discounted FCF of year 8:

= FCF of year 9 x Present value factor at 15% for 8 years

= 1470300 x 0.326902

= 480643.9

Computation of net present value:

= Initial FCF + Discounted FCF of year 1 to 7 + Discounted FCF of year 8

= -1870000 + 2518654 + 480643.9

= 1129297.9