Question

Question 3 (14 marks) A project has an initial investment of $300,000 for fixed equipment. The fixed equipment will be depreciated on a straight-line basis to zero book value over the three-year life of the project and have zero salvage value. The project also requires $38,000 initially for net working capital. All net working capital will be recovered at the end of the project. Sales from the project are expected to be $300,000 per year and operating costs amount to $100,000 per year. The tax rate is 30 percent. (Show all workings) (a) Calculate the initial cash flow (the cash flow at Year 0). (2 marks) (b) Calculate the operating cash flow (OCF) using the tax shield approach for each of the three years: Year 1, Year 2 and Year 3 (ſinal year). (6 marks) (c) If the discount rate is 12 percent, calculate the project's net present value (NPV). (3 marks) (d) Determine and explain whether the project should be accepted or not. (3 marks)

Answer 1

(a) Initial cash flow = Fixed asset costs+ net working capital

=$(300,000 + 38,000)

=$338,000

Depreciation = 300,000/3 = $ 100,000 per year

(b) Operating cash flow (OCF) =

Particulars   Amt in $

Sales 300,000

Less operating costs 100,000

Less depreciation 100,000

Income before tax 100,000

Less tax@30% 30,000

Income after tax 70,000

Add depreciation 100,000

OFC 170,000

OFC for

year 1 =$170,000

year 2 =$170,000

year 3 =$(170,000 + 38,000) =$208,000

In year 3 , the net working capital will also be recovered.

(c) NPV = present value of future cashflows - initial investment

= 170,000/(1+12%)¹ + 170,000/(1+12%)² + 208,000/(1+12%)³

= 151,785.71 + 135,522.96 + 148,050.29 - 338,000

=435,358.96 - 338,000

= $97,358.96

(d) The NPV of the project is $ 97,358.96. The NPV of the project is postive , so the company should accept the project.