Teak Furniture Co. is considering a new three-year expansion project that requir
ID: 1193798 • Letter: T
Question
Teak Furniture Co. is considering a new three-year expansion project that requires an initial fixed asset investment of $2,640,000. The fixed asset will be depreciated straight-line to zero over its three-year tax life, after which time it will be worthless. The project is estimated to generate $964,000 in operating cash flow. It will require a $10,000 investment in net working capital. Assume the required return on the project is 6 percent. What is the project’s NPV? Should the firm accept or reject the project?
Explanation / Answer
Initial fixed investment = $2640000
After 3 year working life, fixed asset has no salvage value.
Expected operating cashflow = $964000
Net working capital = $10000
Required return = 6%
Net present value (NPV) equals the present value of net cash inflows generated by a project less the initial investment on the project.
Net working capital is added in initial fixed investment.
As the operating cash flow is the same in all years, we will use the following formula:
NPV = R × [1 (1 + i)-n]/ i Initial Investment
Where
R is the net cash inflow expected in each period;
i is the required rate of return per period;
n are the number of periods during which the project is expected to operate and generate cash inflows.
NPV = 964000 × [1 (1 + 0.06)-3]/ 0.06 – 2650000
= - 73216.48
AS the NPV is negative, this means inflows are less than the outflow in this investment project, so the firm should reject the project.
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