Question

Net Present Value/Cash Flow Estimation word problem. Information is given below.

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FINA 440 Net Present Value Panda Snow Suits Panda Children's Clothing Company is considering expanding its product lines into snow suits. It has spare capacity on its sewing machinery, but would need to buy a new cutting machine for $40000. It expects to increase labor costs by S4000 in the first year, materials by $6,000 in the first year, and overheads by $2000. Sales for the new product line are expected to be $20000 in the first year, $30000 in the second, and then grow by 8% for the next three years. A one time additional promotional campaign costing $5000 will be done at the time the machine is purchased. After the first year, all costs are expected to increase at 4%. The project is expected to be abandoned after 5 years. The machine will be depreciated at straight line over 5 years with no salvage value. The tax rate is 30%. The company's cost of new debt is 8.5%. The company has a beta of 1.2. the risk free rate is 5%, and the return on the market is 15%. The company wants to maintain a capital structure of 40% debt and 60% equity. a. What is the initial investment for this project? b. Set up the cash flows for the next five years. c. What is the company's Weighted Average Cost of Capital? d. What is the net present value of the snow suit project? e. (bonus question) Do you think that sales would grow in the manner described in the problem? Why or why not (explain fully). Do you think that all costs would grow at the same rate for 5 years? Why or why not (explain fully).

Answer 1

Net Investment Straight line Depreciation Sale of old Assets Terminal value Capitalized Costs $40,000 Base $40,000 Selling price SO Terminal value Time Zero Expenses SO Year 5 Book Value SO Present Value of Terminal Value Tax Effects SO Annual Payment $8.000 Gain Loss ISO Total Net Investment $40.000 Tax Effect Calculation of WACC: Ke =Rf+B (Rm-Rf) D:E = 0.4 : 0.6 Cost of Debt after Tax = 8.5% (1-0.3) Cost of Equity = 5% +[1.2 x (15%-5%)] WACC 5.95(0.4) +17(0.6) 5.95% 17.00% 12.58%

Year 5 $34.992 $37.791 -$4.499 -$4.679 -S6.749 -$7,019 -$2.250 -$2.340 Particulars Revenue Less: Operating Costs Material Labor Overheads Less: Other Incremental Costs Less: Depreciation *= EBIT Less : Taxes @ 30% = EBIAT Add: Depreciation *+/- Working Capital Free Cash Flows PV Factor @ WACC 12.58% Discounted Cashflow with WACC - Net Initial Investment Net Present Value Year 1 Year 2 Year 3 Year 4 $20.000 $30,000 $32.400 -$4.000 -$4.160 -$4.326 -S6,000 -S6.240 -S6.490 -$2.000 -$2.080 -$2.163 -S5.000 -$8.000 -$8.0001 -$8.000 -$5,000 $9,520 $11.421 sol -$1,356 -$3,426 -S5.000 $8.164 $7.995 $8.000 $8.000 $8.000 SO sol $3.000 $16,164 $15,995 0.8883 0.7890 0.7008 $2.665 $12.753 $11.210 -S40,000 $8.009 -$8.000 -$8.000 $13,494 $15,753 -$4.048 -$4.726 $9.446 $11.027 58.000 $8.000 SO SO $17,446 19,027 0.6225 0.5530 S10.860 $10.521 SO

A. Initial Investment = $ 40,000

B. Cash flows : See above table.

C. WACC = 12.58%

D. NPV = $ 8009