Problem 2 Your company, Dominant Retailer, Inc., is considering a project whose data are shown below. Revenue and cash operating expenses are expected to be constant over the project's 5 year expected operating life; annual sales revenue is $95,000.00 and cash operating expenses are $37,500.00. The new equipment's cost and depreciable basis is $135,000.00 and it will be depreciated by MACRS as 5 year property. The new equipment replaces older equipment that is fully depreciated but can be sold for $7,500. In addition, the new equipment requires an additional $5,000 of net operating working capital, which can be fully recovered at the end of the project. The new equipment is expected to be sold for $10,995 at the end of the project in year 5. The marginal tax rate is 28.00%. What is the project's Initial Cash Outlay at Year 0? Note: Enter your answer rounded off to two decimal points. Do not enter $ or comma in the answer box. For example, if your answer is $12,300.456 then enter as 12300.46 in the answer box.
Using the information from problem 2 on Dominant Retailer, Inc., what is the NPV of the Project if Dominant Retailer’s WACC is 12.75%? Enter your answer rounded to two decimal places. Do not enter $ or comma in the answer box. For example, if your answer is $12,300.456 then enter as 12300.46 in the answer box.
Calculating projects initial outlay of project in year 0
Cost of new equipment = $135000, Initial investment in working capital = $5000
Salvage value of old equipment = 7500, Book value of old equipment = 0
Net proceeds from sale of old equipment = Salvage value of old equipment - Tax on gain from sale of old equipment = Salvage value of old equipment - tax rate(Salvage value of old equipment - Book value of old equipment) = 7500 - 28%(7500 - 0) = 7500 - 2100 = 5400
Initial outlay in year 0 = Cost of new equipment + Initial investment in working capital - Net proceeds from sale of old equipment = 135000 + 5000 - 5400 = 134600
Projects initial outlay in year 0 = 134600.00
Calculating NPV of the project
Depreciation for a year under 5 year MACRS = Rate of depreciation for a year x Cost of equipment
Rate of depreciation for year 1 under 5 year MACRS = 20%
Depreciation for year 1 under 5 year MACRS = Rate of depreciation for year 1 under 5 year MACRS x 135000 = 27000
Similarly depreciation can be calculated for other years. Depreciation schedule is given in the table below
Depreciation under 5 year MACRS class | |||||
Year | 1 | 2 | 3 | 4 | 5 |
Depreciation rate | 20.00% | 32.00% | 19.20% | 11.52% | 11.52% |
Depreciation | 27000.00 | 43200.00 | 25920.00 | 15552.00 | 15552.00 |
After tax operating cash flow for a year = EBIT(1- tax rate) + Depreciation = (Revenue - expenses - depreciation)(1-tax rate) + depreciation
After tax operating cash flow for year 1 = (95000 - 37500 - 27000)(1-28%) + 27000 = 30500 x 72% + 27000 = 21960 + 27000 = 48960
Similarly we can calculate the after tax operating cash flow for year 2 to year 5, we get the following table of cash flows
Calculating After tax Operating Cash flow | |||||
Year | 1 | 2 | 3 | 4 | 5 |
Revenue | 95000.0000 | 95000.0000 | 95000.0000 | 95000.0000 | 95000.0000 |
Operating costs | 37500.0000 | 37500.0000 | 37500.0000 | 37500.0000 | 37500.0000 |
Depreciation | 27000.0000 | 43200.0000 | 25920.0000 | 15552.0000 | 15552.0000 |
EBIT | 30500.0000 | 14300.0000 | 31580.0000 | 41948.0000 | 41948.0000 |
EBIT(1-tax rate) | 21960.0000 | 10296.0000 | 22737.6000 | 30202.5600 | 30202.5600 |
Plus: Depreciation | 27000.0000 | 43200.0000 | 25920.0000 | 15552.0000 | 15552.0000 |
After tax operating Cash Flow | 48960.0000 | 53496.0000 | 48657.6000 | 45754.5600 | 45754.5600 |
Book value of new equipment at end of year 5 = Cost of new equipment - sum of depreciation for year 1 to 5 = 135000 - (27000 + 43200 + 25920 + 15552 + 15552) = 135000 - 127224 = 7776
Terminal cash flow in year 5 = Salvage value of new equipment at end of 5 years - tax from gain on sale of new equipment + Recovery of investment in net working capital
= Salvage value of new equipment at end of 5 years - tax rate(Salvage value of new equipment at end of 5 years - Book value of new equipment at end of 5 years)- + Recovery of investment in net working capital
= 10995 - 28%(10995 - 7776) + 5000 = 10995 - 901.32 + 5000 = 15093.68
Net present value of project = - Initial outlay in year 0 + Sum of present values of after tax cash flows discounted at WACC + Present value of terminal cash flow discounted at WACC
= - 134600 + 48960 / (1 + 12.75%) + 53496 / (1 + 12.75%)2 + 48657.60 / (1 + 12.75%)3 + 45754.56 / (1 + 12.75%)4 + 45754.56 / (1 + 12.75%)5 + 15093.68 / (1 + 12.75%)5
= -134600 + 43423.5033 + 42081.2090 + 33946.9712 + 28311.8455 + 25110.2843 + 8283.4715 = 46557.2839 = 46557.28 (rounded to two places off decimal)
Hence NPV of the project = 43557.28
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