Question

Mann Co is a listed company. In past several months, the stock price of the Mann Co has continued to decline due to operating losses, which makes the board of directors in face of great pressure. Mann Co board is considering to invest in a new project to improve company's financial performance. According to the prediction of the Mann Co's financial manager, the new project life is expected to be 5 years. At the beginning of the project, the sales volumes and selling price of the products are relatively high. In the later stage of the project, with the entry of competitors, both the sales volume and unit price will decrease. The forecast sales volumes, selling price, variable costs of the projects are as follows: 4 Year Sales (units/year) Selling price ($/unit) Variable cost (S/unit) 110000 300 180 2 120000 300 180 3 120000 300 180 100000 270 5 80000 250 180 180 The equipment needed to begin production has an installed cost of $30 m and the tax law allows Mann Co equipment depreciate to zero over 10 year using straight-line depreciation. Mann Co's financial manager forecast that this equipment can be sold for $2 m after completion of the project. In addition, production of the project will require $1.5m in net working capital to start and additional new working capital investments each year equal to 10% of the projected sales increase for the following years. The financial manager estimates that the annual factory building rental and other fixed expenditures are about $2m for each year. The marginal tax rate of Mann Co is 35% and the require retum on the project is 12%. Required: (a). Calculate the after-tax salvage value of the equipment. (5 marks) (b). Calculate the cash flow from asset for each year. (6 marks) (c). Calculate the Net Present Value of the project. (4 marks) (d). Calculate the Payback period of the project. (2 marks) (e). Would you suggest Mann Co invest this project? Why? (3 marks)

Answer 1

After-Tax salvage value of the equipment A Salvage Value Cost Annual Depreciation Depreciation for 5 years Book Value after 5 years Remaining Book Value Tax Refund After-Tax salvage value of the equipment 20,00,000 3,00,00,000 30,00,000 1,50,00,000 1,50,00,000 1,50,00,000 -45,50,000 (2000000-15000000) *35% 65,50,000 (2000000+4550000) B Oyear 5 80,000 Sales-Units Sales Price-Variable Cost Cash In flow ($'000) 1 1,10,000 120 13,200 2 3 4 1,20,000 1,20,000 1,00,000 120 120 90 14,400 14,400 9,000 70 5,600 с Statement showing NPV $'000 1 2 3 4 5 Cash Out Flow-$'000 Change in Working Capital Oyear -30,000 -1,500 -31,500 -2,100 -2,100 13,200 3,000 10,200 -3,570 3,000 Less - 1,500 -1,500 14,400 3,000 11,400 -3,990 3,000 -1,200 -1,200 14,400 3,000 11,400 -3,990 3,000 -800 -800 9,000 3,000 6,000 Less -2,100 1,500 1,500 5,600 3,000 2,600 -910 3,000 6,550 12,740 0.567 7,229 -13 3,000 Cash In flow ($'000) Depreciation Cash Flow before Tax Tax Depreciation Salvage Value Net Cash Flow Discount Factor-12% Discounted Cash Flow NPV (Sum of present Values) Add Add -31,500 7,530 9,210 0.893 8,910 0.797 7,103 0.712 6,100 0.636 3,877 -31,500 6,723 6,555 Projected Sales Oyear Units Selling Price($ Per unit) Sales-$'000 Working Capital Change in Working Capital 1 1,10,000 300 33,000 -3,600 -2,100 1,20,000 1,20,000 1,00,000 300 300 270 36,000 36,000 27,000 -3,600 -2,700 -2,000 -1,500 -1,200 -800 80,000 250 20,000 1,500 1,500 -1,500 - 1,500 D Pay Back Period The payback period is the time required to earn back the amount invested in an asset from its net cash flows Year 0 1 Net Invested Cash Flow Cash Flow -28,000 (30000-2000) -14,800 14,400 -400 14,400 9,000 5,600 13,200 2 3 4 5 Pay Back Period 3 years+a few days E Since NPV is negative, It is advised not to invest in project