Question

H. Cochran, Inc., is considering a new three-year expansion project that requires an Initial fixed asset investment of $2,430,000. The fixed asset will be depreciated straight- line to zero over its three-year tax life. The project is estimated to generate $2,810,000 in annual sales, with costs of $1,790,000. The project requires an initial Investment in net working capital of $166,000 and the fixed asset will have a market value of $201,000 at the end of the project. Assume that the tax rate is 24 percent and the required return on the project is 10 percent. a. What are the net cash flows of the project each year? (A negative answer should be Indicated by a minus sign. Do not round Intermediate calculations and round your answers to the nearest whole number, e.g., 32.) b. What is the NPV of the project? (Do not round Intermediate calculations and round your answer to 2 decimal places, e.g., 32.16.) a. Year 0 cash flow Year 1 cash flow Year 2 cash flow Year 3 cash flow b. NPV

Answer 1

Answer

Initial investment in fixed assets = 2430000

Depreciation straight line over three year use full life

Generate sales = 2810000 per year

Cost = 1790000 per year

Increase in Net working capital = 166000

Salvage value (market value) = 201000

Tax rate = 24%

Required rate of return = 10%

A. Year 0 cash flow	- $ 2596000
Year 1 cash flow	$ 969600
Year 2 cash flow	$ 969600
Year 3 cash flow	$ 1288360
B. NPV	$ 54588.71

a.

1. Year 0 cash flow =

Initial investment in fixed assets = 2430000

Increase in Net working capital = 166000

Net initial investment in 0 year ( 0 th year cash outflow ) = 2430000 + 166000 = 2596000

2. Year 1 cash flow

   Increase in sales = 2810000

   - Increase in Cost = 1790000

  =Net increase In earning before tax = 1020000

  - Tax at rate 24% = 1020000 * 24% = 244800

  = Earning after tax (excluding depreciation) = 775200

  + depreciation tax shield = 194400

  = Net operating cash flow = 775200 + 194400 = 969600

3. Year 2 cash flow

   Increase in sales = 2810000

   - Increase in Cost = 1790000

  =Net increase In earning before tax = 1020000

  - Tax at rate 24% = 1020000 * 24% = 244800

  = Earning after tax (excluding depreciation) = 775200

  + depreciation tax shield = 194400

  = Net operating cash flow = 775200 + 194400 = 969600

4. Year 3 cash flow

   Increase in sales = 2810000

   - Increase in Cost = 1790000

  =Net increase In earning before tax = 1020000

  - Tax at rate 24% = 1020000 * 24% = 244800

  = Earning after tax (excluding depreciation) = 775200

  + depreciation tax shield = 194400

  = Net operating cash flow = 775200 + 194400 = 969600

  + Net cash flow from sale of asset = 152760

  + Release of working capital = 166000

= Year 3 net cash flow = 969600 + 152760 + 166000 = 1288360

**Net cash flow from sale of asset

  Market value = 201000   ( inflow)

  Book value = 0 ( fully depreciated over 3 year)

  Taxable gain from sale = 201000

  Tax on gain = 201000 * 24% = 48240 (outflow)

Net cash flow from sale = 201000 - 48240 = 152760

**Depreciation = 2430000 / 3 = 810000

depreciation tax shield = Depreciation * tax rate

                = 810000 * 24% = 194400 each three year is same

B. NPV of the project

For this purpose covert cash flow to its present value (PV)

PV of year 0 cash flow = 2596000 * ( 1 / 1 + 10%)0

                          = 4090000 * 1 = 2596000

PV of year 1 cash flow = 969600 * ( 1 / 1+10%)1

                   = 969600 * 0.909 = 881366.4

PV of year 2 cash flow = 969600 * ( 1 / 1+10%)2

                   = 969600 * 0.826= 801277.44

PV of year 3 cash flow = 1288360 * ( 1 / 1+10%)3

                   = 1288360 * 0.7513 = 967944.87

NPV = PV of cash flow - initial investment

NPV = (881366.4 + 801277.44 + 967944.87) - 2596000

NPV = 54588.71