Question

Question 1 Answer 1(a) & 1(d) Your company is considering a new 3-year project that requires an initial investment in equipment of $3 million. Prior to this, you had engaged a consultant to study the feasibility of the new project and after an extensive market survey, the consultant confirmed your belief that the project would be viable. Your company is charged $100,000 for the feasibility study. The equipment will be depreciated straight line to zero over the 3 years of its useful life. In addition, you will need to invest $180,000 in net working capital at the initiation of the project. You estimate that the project will produce sales of $3.5 million every year for 3 years, with costs of $1.5 million. The tax rate is 20%. (a) Calculate the operating cash flow for this project. (10 marks) (b) (i) Explain how depreciation increases the operating cash flow and what is the savings for the firm due to depreciation. (5 marks) (ii) Your colleague tells you that interest expense, if present, should be included in the calculation of operating cash flow because it is a significant expense and it is an actual cash outflow. Is he right? Explain. (5 marks) (c) The equipment has a market value of $250,000 at the end of the project. What is the net salvage value? Should you include it in the calculation of the project's NPV? Show why or why not. Ans: $200,000 (5 marks) (d) The required return on this project is 12%. Taking into account all the above information, determine if you would recommend to invest in this project? (10 marks)

Answer 1

a.) Operating Cashflow($)-

Particular	Year 0	Year 1	Year 2	Year 3
Equipment	-3000000
Net Working Capital	-180000
Sales		3500000	3500000	3500000
Costs		-1500000	-1500000	-1500000
Tax Amount (Note1)		-200000	-200000	-200000
Operating Cashflow		1800000	1800000	1800000

Note 1:

Since Rate of Tax is 20% and to calculate Operating Cash flow then Tax amount to be calculated-

Year 1,2&3

Sales	3500000
Cost	-1500000
Depreciation(3000000/3years)*	-1000000
Total	1000000

Tax amount = 1000000*20% = 200000$

*As it is assumed that the cost does not includes that Depreciation charges.

Note 2. - Consultation fee for a Feasibility study of a project is sunk coost which is not to be included in cost of a project.

d.)

Calculate NPV of the project :

1. Initial Investment-

Equipment- $3000000

Working Cap.- $180000

Total= $3180000 or $3.18m

2. PV of yearly after-tax cash operating Income

= ($3.5m-$1.5m)(1-0.2)* PVIFA(m=3, k=12%)

= $3.8429m

3. PV of yearly tax saving from the depriciation

= ($3 m /3 years * 0.2)* PVIFA (m=3, k=12%)

= $0.4804 m

4. PV of fully recovered Net Working Capital

= $0.18 m * PVIF (m=3, k=12%)

= $0.1281 m

5. Total Net Inflow= 2+3+4

= $4.4514

NPV of project = 5-1

= $4.4514- $3.18 m =$1.2714 m

Since, the NPV of the project is Positive so the project is viable.