Question

9.30:

After spending $ 9 comma 900 on​ client-development, you have just been offered a big production contract by a new client. The contract will add $ 196 comma 000 to your revenues for each of the next five years and it will cost you $ 99 comma 000 per year to make the additional product. You will have to use some existing equipment and buy new equipment as well. The existing equipment is fully​ depreciated, but could be sold for $ 47 comma 000 now. If you use it in the​ project, it will be worthless at the end of the project. You will buy new equipment valued at $ 27 comma 000 and use the​ 5-year MACRS schedule to depreciate it. It will be worthless at the end of the project. Your current production manager earns $ 80 comma 000 per year. Since she is busy with ongoing​ projects, you are planning to hire an assistant at $ 39 comma 000 per year to help with the expansion. You will have to immediately increase your inventory from $ 20 comma 000 to $ 30 comma 000. It will return to $ 20 comma 000 at the end of the project. Your​ company's tax rate is 35 % and your discount rate is 15.5 %. What is the NPV of the​ contract? Note​: Assume that the equipment is put into use in year 1.

Answer 1

		Amount of $9900 spent is sunk cost, not relevant to this analysis
	a	Net Cash Flow at time 0
		After tax Opportunity Cost of not selling existing equipment	($30,550)	(47000*(1-0.35)
		Investment in new equipment	($27,000)
		Net increase in inventory=30000-20000	($10,000)
		Net Cash Flow at time 0=	($67,550)
	b	Annual Cash Flow
		Addition to revenue	$196,000
		Cost of making	($99,000)
		Salary of planning assistant	($39,000)
		Annual Before tax cash flow	$58,000
		Annual after tax cash flow =(58000*(1-0.35)	$37,700
	c	Depreciation Tax shield
		Year	1	2	3	4	5
	A	5 Year MACRS Depreciation Rate	20%	32%	19.20%	11.52%	11.52%
	B=A*27000	Annual Depreciation	$5,400	$8,640	$5,184	$3,110	$3,110
	C=B*35%	Depreciation Tax shield	$1,080	$2,765	$995	$358	$358
	d	Terminal Cash Flow:
		Release of working Capital	$10,000
	e	NPV (Net Present Value) of the contract
		Present Value of Cash Flow=(Cash Flow)/((1+i)^N)
		i= discount rate=15.5%=0.155, N=Year of Cash Flow
	N	Year	0	1	2	3	4	5
	a	Initial Cash flow	($67,550)
	b	Annual Cash Flow		$37,700	$37,700	$37,700	$37,700	$37,700
	c	Depreciation tax shield		$1,080	$2,765	$995	$358	$358
	d	Terminal Cash flow						$10,000
	CF=a+b+c+d	Net Cash Flow	($67,550)	$38,780	$40,465	$38,695	$38,058	$48,058	SUM
	PV=CF/(1.155^N)	Present Value of Net Cash Flow at15.5% discount	($67,550)	$33,576	$30,333	$25,114	$21,386	$23,381	$66,239
	NPV=Sum of PV	Net Present Value	$66,238.80