Question

AAA Corp. currently has one product, high-priced lawn mowers. AAA Corp. has decided to sell a new line of medium-priced lawn mowers. The building and machinery for producing this new line is estimated to cost $11,000,000 and it will be depreciated down to zero over 20 years using straight-line depreciation. Also, an investment today on working capital in the amount of $4,000,000 is needed. The working capital will be recovered at the end of the project. Sales for the new line of lawn mowers are estimated at $26 million a year. Annual variable costs are 60% of sales. The project is expected to last 10 years. In addition to the production variable costs, the fixed costs each year will be $4,000,000. The company has spent $1,000,000 in a marketing study that determined the company will lose $11 million in sales a year of its existing high-priced lawn mowers. The production variable cost of these sales is $9 million a year. It is expected that at the end of the project, the building and machinery can be sold for $2,000,000. The tax rate is 20 percent and the cost of capital is 12%. a. What is the initial outlay (10) for this project? The Initial Outlay is $ - (Round your answer to the nearest dollar- no decimals - and commas are required to separate thousands and millions. Use negative sign for negative cash flows - do not use parenthesis). b. What is the operating cash flows (OCF) for each of the years for this project? The OCF for each year of the project are $ (Round your answer to the nearest dollar - no decimals - and commas are required to separate thousands and millions). c. What is the termination value (TV) cash flow (aka recovery cost or after-tax salvage value, or liquidation value of the assets) at the end of the project? The termination value at the end of the project is $ . (Round your answer to two the nearest dollar - no decimals - and commas are required to separate thousands and millions). d. What is the NPV of this project? The NPV of this project is $ . (Round your answer to the nearest dollar - no decimals - and commas are required to separate thousands and millions. Use negative sign for negative cash flows - do not use parenthesis).

Answer 1

a]

initial outlay = cost of building and machinery + investment in working capital

initial outlay = $11,000,000 + $4,000,000 = $15,000,000

The amount spent on marketing study is a sunk cost because it is incurred in the past and cannot be recovered. It is not incremental to the acceptance of the project, and hence should not be considered in the cash flow analysis

b]

Operating cash flow (OCF) each year = incremental income after tax + depreciation

incremental income before tax = revenues - variable costs - fixed costs - depreciation - lost contribution of high-priced mowers

Lost contribution of high-priced mowers = lost sales - variable costs = $11,000,000 - $9,000,000 = $2,000,000

OCF = $3,630,000

c]

loss on sale of equipment at end of year 10 = book value - sale price

book value = original cost - accumulated depreciation

after-tax salvage value = salvage value + tax benefit on loss on sale of equipment (the loss is tax deductible, and hence reduces the tax outgo. This is treated as a cash inflow)

Termination value = after-tax salvage value + recovery of working capital

Termination value = $6,700,000

d]

NPV is calculated using NPV function in Excel

NPV is $7,667,530

B C D E F G H I J K L 0 1 2 3 4 5 6 7 8 9 10 2 3 4 Initial Investment Cost of building and machinery Investment in working capital $11,000,000 $4,000,000 6 OCE 7 Revenues 8 - Variable Costs 9 - Fixed Costs 10 - Depreciation 11 - Lost contribution of high-priced mowers 12 Incremental income before tax 13 - Taxes 14 Incremental income after tax 15 + Depreciation 16 OCF $26,000,000 $15,600,000 $4,000,000 $550,000 $2,000,000 $3,850,000 $770,000 $3,080,000 $550,000 $3,630,000 $26,000,000 $26,000,000 $15,600,000 $15,600,000 $4,000,000 $4,000,000 $550,000 $550,000 $2,000,000 $2,000,000 $3,850,000 $3,850,000 $770,000 $770,000 $3,080,000 $3,080,000 $550,000 $550,000 $3,630,000 $3,630,000 $26,000,000 $15,600,000 $4,000,000 $550,000 $2,000,000 $3,850,000 $770,000 $3,080,000 $550,000 $3,630,000 $26,000,000 $26,000,000 $15,600,000 $15,600,000 $4,000,000 $4,000,000 $550,000 $550,000 $2,000,000 $2,000,000 $3,850,000 $3,850,000 $770,000 $770,000 $3,080,000 $3,080,000 $550,000 $550,000 $3,630,000 $3,630,000 $26,000,000 $26,000,000 $26,000,000 $15,600,000 $15,600,000 $15,600,000 $4,000,000 $4,000,000 $4,000,000 $550,000 $550,000 $550,000 $2,000,000 $2,000,000 $2,000,000 $3,850,000 $3,850,000 $3,850,000 $770,000 $770,000 $770,000 $3,080,000 $3,080,000 $3,080,000 $550,000 $550,000 $550,000 $3,630,000 $3,630,000 $3,630,000 $26,000,000 $15,600,000 $4,000,000 $550,000 $2,000,000 $3,850,000 $770,000 $3,080,000 $550,000 $3,630,000 18 Terminal Cash Floy_ 19 Salvage Value 20 Accumulated depreciation 21 Book value of building and machinery 22 Loss on sale 23 Tax benefit on loss 24 Salvage Value after tax 25 Recovery of working capital 26 Terminal Cash Flow 27 28 NPV Analysis 29 Project Cash Flows 30 31 NPV $2,000,000 $5,500,000 $5,500,000 $3,500,000 $700,000 $2,700,000 $4,000,000 $6,700,000 ($15,000,000) $3,630,000 $3,630,000 $3,630,000 $3,630,000 $3,630,000 $3,630,000 $3,630,000 $3,630,000 $3,630,000 $10,330,000 $7,667,530