Question

You start a new 3 year bicycle manufacturing project using an initial investment of $450,000 to buy new equipment. Prior to launching your business, you paid $25,000 to a consultant who helped you put together a business proposal. Your business is able to sell 1,000 bicycles per year for a selling price of $2,500, variable cost of $1,200 per bicycle, and fixed costs per year of $350,000. Assume you depreciate your equipment straight-line over a 3 year period, anticipate inventory to go up $500 at year 0 (with full recovery at the end of the project), and have a corporate tax rate of 20.0%, all capital expenditure is spent at year 0 and you have a WACC of 8.8%. (Use spreadsheet to solve this problem)

What is the total cash outflow during year 0 -450500,-400000,-50000,-450000

Free cash flow of project during year 1 790,000, 700,000, 650,000, 810,000

NPV of the project 1,3 mil, 2,1 mil, 1,6 mil, 2 million

Answer 1

a). Initial Investment = Cost of Equipment + Net Investment in Inventory = $450,000 + $500 = $450,500

So, Total Cash Outflow = -$450,500

Hence, Option "A" is correct.

b). Depreciation = Cost of Equipment / No. of useful life years

= $450,000 / 3 = $150,000

Cash Flow during Year 1 = [{(Selling Price - Variable Cost) x Qty. Sold} - Fixed Cost] x (1 - tax rate) + [Depreciation x tax rate]

= [{($2,500 - $1,200) x 1,000} - $350,000] x (1 - 0.20) + [$150,000 x 0.20]

= $760,000 + $30,000 = $790,000

Hence, Option "A" is correct.

c). Cash Flow during Year 2 = Cash Flow during Year 1 = $790,000

Cash Flow during Year 3 = Cash Flow during Year 1 + Recovery of Investment in inventory

= $790,000 + $500 = $790,500

NPV = PV of Cash Infows - PV of Cash Outflows
= [$790,000 / 1.088] + [$790,000 / 1.088²] + [$790,500 / 1.088³] - $450,500

= $726,102.94 + $667,374.03 + $613,783.47 - $450,500 = $1,556,760.44, or $1.6 million

Hence, Option "C" is correct.