8. The Volunteer Company (VC) produces electrical switching components and is co
ID: 2498883 • Letter: 8
Question
8. The Volunteer Company (VC) produces electrical switching components and is considering manufacturing a new component that will require new equipment. The production of this component will require $1,500,000 in net working capital to start and additional net working capital investments each year equal to 15 percent of the projected sales increases for the following year. Total fixed costs are $1,350,000 per year, variable production costs are $225 per unit and the units are priced at $345 each. The equipment needed to begin production has an installed cost of $23,000,000. The equipment is considered to qualify as seven-year MACRS property. In five years, the equipment can be sold for 20 percent of its acquisition cost. VC is in the 35 percent marginal tax bracket and has a required return on all its projects of 18 percent. Based on the preceding project estimates, answer the following questions:
Questions
A. What is the total cash flow of the project for Year 3?
B. What is the NPV of the project?
C. What is the IRR of the project?
D. Should VC begin this project?
Explain Note: An income statement must be prepared for each year. Beginning with the initial cash flow at time zero, the project will require an investment in equipment. The project will also require an investment in net working capital. The Net will be Year 1 sales. To assist in your calculation, total sales per year are provided. To calculate depreciation, use the original equipment cost of $23 million times the appropriate MACRS depreciation each year. To determine the after-tax salvage value, the book value of the equipment must be determined. Book value for each year is the purchase price of the equipment ($23 million) less accumulated depreciation. As a check, ending book value for year 5= $5,131,300. Also the capital spending for year 5= (equipment cost x 20% = $4.6 million). After-tax salvage value = $4,600,000 + ($5,131,300 - 4,600,000) (.35) = $4,785,955.
Increase in Net Working Capital for Year 1 = .15($43,815,000 - $37,260,000) = $983,250; this increase is negative given the increase in sales for year 2. Net Working Capital Increases for the remaining years are positive because sales are declining.
CONTINUED 8 The required cash flow at the beginning of the project: Equipment purchase price = $23,000,000 Change in Net Working Capital = 1,500,000 Total cash flow (out) = $24,500,000
Use the following format to calculate the total cash flow. Enter the missing values (Your instructor has provided certain calculations to get you started)
Year
1
2
3
4
5
Ending book
value
$19,713,300
$5,131,300
Sales
$37,260,000
$43,815,000
$39,675,000
$33,810,000
$28,980,000
Variable costs
24,300,000
Fixed costs
1,350,000
Depreciation
3,286,700
EBIT
8,323,300
Taxes
2,913,155
Net income
5,410,145
Depreciation
3,286,700
Operating cash flow
$8,696,845
$10,999,945
$9,500,445
$7,771,945
$6,393,365
Net cash flows
Operating cash flow
$8,696,845
Change in NWC
983,250
621,000
Capital spending
0
0
0
0
4,785,955
Total cash flow
$7,713,595
$11,437,320
Year
1
2
3
4
5
Ending book
value
$19,713,300
$5,131,300
Sales
$37,260,000
$43,815,000
$39,675,000
$33,810,000
$28,980,000
Variable costs
24,300,000
Fixed costs
1,350,000
Depreciation
3,286,700
EBIT
8,323,300
Taxes
2,913,155
Net income
5,410,145
Depreciation
3,286,700
Operating cash flow
$8,696,845
$10,999,945
$9,500,445
$7,771,945
$6,393,365
Net cash flows
Operating cash flow
$8,696,845
Change in NWC
983,250
621,000
Capital spending
0
0
0
0
4,785,955
Total cash flow
$7,713,595
$11,437,320
Explanation / Answer
1) NPV of the project at 18% = $6082364
2) Year 3 total cash flow = $10380195
3) IRR of the project is tha rate of return at which NPV is zero and calculated as follows:
By interepolation
IRR = 18% + (40%-18%) * [(0-6082364) / (-4940080-6082364) ] = 30.14%
4) VC should start the project as NPV is $6082364 and IRR is greater than the required rate of return.
Note.
at the end of the fifth year
recovery of working capital = 1500000+983250 - 621000 - 879750 - 724500 = $258000
year 0 1 2 3 4 5 NPV Cost of equipment -23000000 Working Capital -1500000 ending book value 19713300 14080600 10057900 7185200 5131300 sales 37260000 43815000 39675000 33810000 28980000 variable cost 24300000 28575000 25875000 22050000 18900000 fixed cost 1350000 1350000 1350000 1350000 1350000 dperciation 3286700 5632700 4022700 2872700 2053900 EBIT 8323300 8257300 8427300 7537300 6676100 tax 2913155 2890055 2949555 2638055 2336635 Net income 5410145 5367245 5477745 4899245 4339465 depreciation 3286700 5632700 4022700 2872700 2053900 operating cash flow 8696845 10999945 9500445 7771945 6393365 net cash flow operating cash flow 8696845 10999945 9500445 7771945 6393365 change in NWC -983250 621000 879750 724500 258000 capital spending 0 0 0 0 4785955 total cash flow -24500000 7713595 11620945 10380195 8496445 11437320 PV factor @ 18% 1 0.847458 0.718184 0.608631 0.515789 0.437109 PV of cash flows -24500000 6536945 8345982 6317707 4382372 4999358 6082364 pv factor @ 40% 1 0.714286 0.510204 0.364431 0.260308 0.185934 PV of cash flows -24500000 5509711 5929054 3782870 2211694 2126592 -4940080Related Questions
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