Cochrane, Inc., is considering a new three-year expansion project that requires

Question

Cochrane, Inc., is considering a new three-year expansion project that requires an initial fixed asset investment of $2,310,000. The fixed asset will be depreciated straight-line to zero over its three-year tax life. The project is estimated to generate $2,220,000 in annual sales, with costs of $1,210,000. The project requires an initial investment in net working capital of $157,000, and the fixed asset will have a market value of $182,000 at the end of the project. Assume that the tax rate is 30 percent and the required return on the project is 11 percent.

1) What are the net cash flows of the project for the years 0 1, 2, and 3?

2) What is the NPV of the project?

DO NOT ROUND

Explanation / Answer

Part 1)

Year 0 cash flow would comprise of initial fixed asset investment and net working capital. Year 1 and Year 2 cash flows would be calculated with the use of following formula:

Operating Cash Flow (Year 1 and Year 2) = (Sales - Costs - Depreciation)*(1-Tax Rate) + Depreciation

Cash flow for Year 3 would comprise of operating cash flow, recovery of working capital and market value after adjustment for tax rate. The formula would be:

Cash Flow (Year 3) = Operating Cash Flow + Recovery of Working Capital + Market Value*(1-Tax Rate)

Here, Depreciation = Cost of the Asset/Life of the Asset

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Using the information provided in the question in the above formulas, we get,

Depreciation = $2,310,000/3 = $770,000

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Year 0 Cash Flow = -2310000 - 157000 = -2,467,000

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Operating Cash Flow (Year 1 and Year 2) = (2,220,000 - 1,210,000 - 770,000)*(1-30%) + 770,000 = $938,000

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Cash Flow Year 3 = 938,000 + 157,000 + 182,000*(1-30%) = $1,222,400

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Tabular Representation:

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Part 2)

NPV is the difference between the present value of costs and present value of cash inflows expected from the project. The formula for calculating NPV is:

NPV = Cash Flow Year 0 + Cash Flow Year 1/(1+Required Return)^1 + Cash Flow Year 3/(1+Required Return)^2 + Cash Flow Year 3/(1+Required Return)^3 and so on.

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Using the cash flows calculated in Part 1 in the above formula, we get,

NPV = -2,467,000 + 938,000/(1+11%)^1 + 938,000/(1+11%)^2 + 1,222,400/(1+11%)^3 = $33,155.23

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