Question

Project NPV United Pigpen is considering a proposal to manufacture high-protein hog feed. The project would make use of an existing warehouse, which is currently rented out to a neighboring firm. The next year’s rental charge on the warehouse is $100,000, and thereafter the rent is expected to grow in line with inflation at 4% a year. In addition to using the warehouse, the proposal envisages an investment in plant and equipment of $1.2 million. This could be depreciated for tax purposes straight-line over 10 years. However, Pigpen expects to terminate the project at the end of eight years and to resell the plant and equipment in year 8 for $400,000. Finally, the project requires an initial investment in working capital of $350,000.

Thereafter, working capital is forecasted to be 10% of sales in each of years 1 through 7. Year 1 sales of hog feed are expected to be $4.2 million, and thereafter sales are forecasted to grow by 5% a year, slightly faster than the inflation rate. Manufacturing costs are expected to be 90% of sales, and profits are subject to tax at 35%. The cost of capital is 12%. What is the NPV of Pigpen’s project?

Answer 1

NPV (Net Present Value): The difference between the present values of cash inflows and present value of initial investment (cash out flows) is known as NPV. A project would be accepted if its NPV is positive. A positive NPV tells that the project will earn enough money to pay out the initial cost and add value for the investors. The NPV is considered as the most reliable method to evaluate projects.

Company UP is considering the usage of existing warehouse and the rent payment for the same is $100,000. The inflation rate is 4% for the rent. The plant and equipment cost is $1,200,000.

The plant and equipment is depreciated straight line over 10 years but is resold in year 8 for $400,000. Initial working capital is $350,000 and 10% of sales for years 1 to 7. Sales for year 1 are $420,000 and will increase by 5% each year. The manufacturing cost of 90% of sales. The tax rate is 35% and cost of capital is 12%.

Follow the steps below to calculate the NPV of the project as follows:

Step:1

Calculate the Operating Cashflows and After-tax salvage value as follows:

Formulas used:

Results obtained:

Therefore, the after-tax salvage value is $344,000.

Note:

OCF is the operating cashflows

Mnf costs are manufacturing costs

Dep is depreciation.

PBT is profit before taxes

PAT is profit after taxes

Step:2

Calculate the NPV of the project as follows:

Formulas used:

Results obtained:

Therefore, the NPV (Net Present Value) of the investment is .

Note: Kindly check the step:1 for proper cell references.