Question

After spending $500,000 to study the potential market for a new specialty chemical, Hart Industries is considering a new six-year project requiring an initial investment in new construction and equipment. The new chemical is expected to reduce after-tax cash flows of the company’s existing products by $1 million each year. The company will purchase $6,000,000 in new plant and equipment. The IRS will allow Hart to depreciate the plant and equipment to a salvage value of 0 on straight-line basis over a six-year useful life. At the end of year six they expect to be able to sell the plant and equipment for $2,000,000. The firm estimates revenue will be $22 million per year for each of the next six years. Assume all of the company’s revenue has a variable cost of 70% of revenue. Fixed costs for the project are estimated to be $3,000,000 annually Start-up net working capital requirements for the project are expected to be $1,000,000 (Assume net working capital is 0 before Hart takes the project). In addition, the company will reduce working capital $100,000 each year due to increased efficiencies. At the end of the six-year project, the net working capital will no longer be required. Should you include the $500,000 spent on studying the potential market as cost when you analyze the project? Why? Should you include the $1 million after-tax cash flows reduction when you analyze the project? Why? Hart’s opportunity cost of capital is 15%, their marginal tax rate is 30%. Calculate the NPV of this project.

Answer 1

$500,000 should not include in the project cashflows because these are costs that incurred to assess whether to take up the project or not. These costs are called sunk costs. sunk costs are unavoidable, even if the project is not undertaken. So, will should not include these costs.

Sometimes, company takes up projects which could eat way the cashflows of other products in the company's portfolio. This is called cannibalization effect and these costs should subtract from the cashinflows.

NPV is positive at $15.19 million and hence company should accept this project

NPV can be calculated using an excel sheet

NPV(rate,6 year cashflows)+initial cashoutflow

Initial cash outlay 7000000 Rate 15% Year1 Year2 Year3 Year4 Year5 Year6 22000000 22000000 22000000 22000000 22000000 22000000 15400000 15400000 15400000 15400000 15400000 15400000 3000000 3000000 3000000 3000000 3000000 3000000 1000000 1000000 1000000 1000000 1000000 1000000 100000 100000 100000 100000 100000 100000 2700000 2700000 2700000 2700000 2700000 2700000 810000 810000 810000 810000 810000 810000 1890000 1890000 1890000 1890000 1890000 1890000 Revenue (A) Variable cost (B) Fixed cost C Depreciation (D) Increased effeciencies E EBIT (A-B-C-D+E) Taxes at 30% Operating income after taxes EBIT-Tax expense Depreciation will be add back as it a non Depreciation cash expense After tax operating cashflow Op. income after taxes+depreciation We should subtract this because it is eating away the company's other project Cannibalization cost cashflows After tax operating cashflow- Actual after tax cashflow cannibalization cost After tax salvage value Net working capital no longer required 1000000 1000000 1000000 1000000 1000000 1000000 2890000 2890000 2890000 2890000 2890000 2890000 1000000 1000000 1000000 1000000 1000000 1000000 1890000 1890000 1890000 1890000 1890000 1890000 1400000 1000000 Total after tax cashflows 1890000 1890000 1890000 1890000 1890000 4290000 NPV 15190258.52

Cashoutflow=$600000+working capital requirement of $100000=$700000

We should take the after tax salvage value which comes in Year 6 and add the working capital which is no longer required.