A construction company is considering an expansion project. So far, they have sp

Question

A construction company is considering an expansion project. So far, they have spent $75,000 investigating the viability of the project and have decided to proceed. The proposed project will cost approximately $450,000 in addition to the $75,000 that was spent on the feasibility study. The project will be depreciated over a three year MACRS class life. The construction company would use the 3-year MACRS method to depreciate the machine and equipment which are 33%, 45%, 15% and 7%. If the project is undertaken the company will need to increase its inventories by $50,000, and its accounts payable will rise by $10,000. The company will realize an additional $600,000 in sales over each of the next three years. The company

Explanation / Answer

Solution:

The company's EBIT = Sales - operating costs - depreciation

Present value of cash flows = $ 179,400 / ( 1+0.095)1 + $ 201,000 / ( 1+0.095)2 + $ 147,000 / (1+0.095)3

Present value of cash flows = $ 163,835.61 + $ 167,636.20 + $ 111,963.11

Present value of cash flows = $ 443,434.92

Net present value = -$ 585,000 +  $ 443,434.92 + present value of salvage value

NPV =  -$ 585,000 +  $ 443,434.92 +$ 38,082.69

NPV = -$ 103,482.38

To calculate the IRR

IRR = 41% + 586,719.58 - 585,000 / 586719.58 - 579,494.68

IRR = 41% + 1719.58 /

IRR = 41.24%

Year Depreciation Cost of the equipment = $ 450,000 1 33% $148,500 2 45% $202,500 3 15% $67,500 Equipment cost feasibility study cost increase in inventories account payable Total cost of investment Cost of the investment $450,000.00 $75,000 $50,000.00 $10,000 $585,000.00 Year Operating costs Sales Depreciation per year Earnings before interest and taxes taxes = 40% Operating cash flows = EBIT + Depreciation - taxes 1 $400,000.00 $600,000 $148,500 $51,500.00 $20,600.00 $179,400.00 2 $400,000.00 $600,000 $202,500 ($2,500.00) ($1,000.00) $201,000.00 3 $400,000.00 $600,000 $67,500 $132,500.00 $53,000.00 $147,000.00

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