Question

United Pigpen is considering a proposal to manufacture high-protein hog feed. The project would require use of an existing warehouse, which is currently rented out to a neighboring firm. The next year’s rental charge on the warehouse is $200,000, and thereafter, the rent is expected to grow in line with inflation at 4% a year. In addition to using the warehouse, the proposal envisages an investment in plant and equipment of $1.80 million. This could be depreciated for tax purposes straight-line over 10 years. However, Pigpen expects to terminate the project at the end of 8 years and to resell the plant and equipment in year 8 for $600,000. Finally, the project requires an immediate investment in working capital of $450,000. Thereafter, working capital is forecasted to be 10% of sales in each of years 1 through 7. Working capital will be run down to zero in year 8 when the project shuts down. Year 1 sales of hog feed are expected to be $6.20 million, and thereafter, sales are forecasted to grow by 5% a year, slightly faster than the inflation rate. Manufacturing costs are expected to be 90% of sales, and profits are subject to tax at 25%. The cost of capital is 12%.

What is the NPV of Pigpen’s project? (Do not round intermediate calculations. Enter your answer in dollars not in millions, rounded to the nearest whole dollars.)

Answer 1

Solution

Calculation of  the NPV of Pigpen’s project is as under:

Year	0	1	2	3	4	5	6	7	8
Sales		6,200,000.00	6,510,000.00	6,835,500.00	7,177,275.00	7,536,138.75	7,912,945.69	8,308,592.97	8,724,022.62
Manufacturing Cost		(5,580,000.00)	(5,859,000.00)	(6,151,950.00)	(6,459,547.50)	(6,782,524.88)	(7,121,651.12)	(7,477,733.67)	(7,851,620.36)
Warehouse Rental Income		(200,000.00)	(208,000.00)	(216,320.00)	(224,972.80)	(233,971.71)	(243,330.58)	(253,063.80)	(263,186.36)
Depreciation (Note 1)		(180,000.00)	(180,000.00)	(180,000.00)	(180,000.00)	(180,000.00)	(180,000.00)	(180,000.00)	(180,000.00)
Profit Before Tax		240,000.00	263,000.00	287,230.00	312,754.70	339,642.16	367,963.99	397,795.49	429,215.91
Tax		(60,000.00)	(65,750.00)	(71,807.50)	(78,188.68)	(84,910.54)	(91,991.00)	(99,448.87)	(107,303.98)
Profit After Tax		180,000.00	197,250.00	215,422.50	234,566.03	254,731.62	275,972.99	298,346.62	321,911.93
Depreciation		180,000.00	180,000.00	180,000.00	180,000.00	180,000.00	180,000.00	180,000.00	180,000.00
Cash flow after tax		360,000.00	377,250.00	395,422.50	414,566.03	434,731.62	455,972.99	478,346.62	501,911.93
Initial Investment	(1,800,000.00)
Working Capital (Note 2)	(450,000.00)	(170,000.00)	(31,000.00)	(32,550.00)	(34,177.50)	(35,886.38)	(37,680.69)	(39,564.73)	-
Release of Working Capital									830,859.30
Resell Value									600,000.00
Total Net Cash Flows	(2,250,000.00)	190,000.00	346,250.00	362,872.50	380,388.53	398,845.25	418,292.30	438,781.89	1,932,771.23
Cost of Capital	12%
NPV`	=NPV(rate, value1,value2,value3..)
NPV	$100,921.81

Hence,  the NPV of Pigpen’s project is $ 100,921.81

Note 1: Calculation of Depreciation

= (Cost of Investment - Salvage Value) / useful life

= ($ 1,800,000 - 0)/ 10 = $ 180,000.00

Note 2: Calculation of Additional Working Capital required every year

Year	0	1	2	3	4	5	6	7	8
Sales		6,200,000.00	6,510,000.00	6,835,500.00	7,177,275.00	7,536,138.75	7,912,945.69	8,308,592.97	8,724,022.62
Working Capital	450,000.00	620,000.00	651,000.00	683,550.00	717,727.50	753,613.88	791,294.57	830,859.30	0
Additional Working Capital requirement		170,000.00	31,000.00	32,550.00	34,177.50	35,886.38	37,680.69	39,564.73	(830,859.30)