Consider the following for an 8 year special revenue generating project. (this i

Question

Consider the following for an 8 year special revenue generating project.   (this is the base case)

Sales revenue $250,000 in the first year and will increase by 20% per year for the next 4 years. In year 6 the revenue will decrease by 15% a year through year 8. There is no expected cash flow after 8 years as this venture has a constrained timeline and no expected value after 8 years.

Costs of goods sold will be 70% of sales.

Advertising and administrative expenses will be fixed at $10,000 per year.

Equipment will be purchased for $300,000 and will be depreciated using the 7 year MACRS asset class depreciation schedule.   Salvage value is expected to be $25,000

Working capital investment in year 0 is estimated to be $20,000 and is expected to be recovered in the final year of the project.  

Cost of Capital is 8% and Tax Rate is 30%.

A: Base Case scenario

Calculate the project’s NPV

What is your recommendation?

B: Pessimistic View

What is the impact on NPV based on pessimistic assumptions (consider both at the same time):

If Sales Revenue in the first year was only $150,000 and only increase by 10% for the next 4 years and then decline by 20% a year through year 8?

If Cost of Goods Sold were 75% of sales?

Explanation / Answer

A Year Sales Cost of goods sold Gross Profit(Sales- Cost of goods sold) Advertising & Administrative expenses Depreciation Net Profit= Gross Profit- Advertising and Admn- Depreciation Depreciation tax shield= Depreciation*Tax Cash flows= Net profit+Depreciation Tax shield 0 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 1 250000.00 175000.00 75000.00 10000.00 42870.00 22130.00 6639.00 28769.00 2 300000.00 210000.00 90000.00 10000.00 72870.00 7130.00 2139.00 9269.00 3 360000.00 252000.00 108000.00 10000.00 51870.00 46130.00 13839.00 59969.00 4 432000.00 302400.00 129600.00 10000.00 37470.00 82130.00 24639.00 106769.00 5 518400.00 362880.00 155520.00 10000.00 26790.00 118730.00 35619.00 154349.00 6 440640.00 308448.00 132192.00 10000.00 26760.00 95432.00 28629.60 124061.60 7 374544.00 262180.80 112363.20 10000.00 13380.00 88983.20 26694.96 115678.16 8 318362.40 222853.68 95508.72 10000.00 0.00 85508.72 25652.62 111161.34 Net Present Value Year Cash Flows Present Value factor@8% Present Value 0 -320000 1.00 -320000.00 1 28769.00 0.93 26637.96 2 9269.00 0.86 7946.67 3 59969.00 0.79 47605.33 4 106769.00 0.74 78478.40 5 154349.00 0.68 105047.34 6 124061.60 0.63 78179.85 7 115678.16 0.58 67497.10 8 156161.34 0.54 84369.11 Net Present Value 175761.76 (Year 8 Cash flow includes Salvage Value of the equipment and working capital recovered) As the NPV is positive, the project is viable. B Year Sales Cost of goods sold Gross Profit(Sales- Cost of goods sold) Advertising & Administrative expenses Depreciation Net Profit= Gross Profit- Advertising and Admn- Depreciation Depreciation tax shield= Depreciation*Tax Cash flows= Net profit+Depreciation Tax shield 0 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 1 250000.00 187500.00 62500.00 10000.00 42870.00 9630.00 2889.00 12519.00 2 275000.00 206250.00 68750.00 10000.00 72870.00 -14120.00 -4236.00 -18356.00 3 302500.00 226875.00 75625.00 10000.00 51870.00 13755.00 4126.50 17881.50 4 332750.00 249562.50 83187.50 10000.00 37470.00 35717.50 10715.25 46432.75 5 366025.00 274518.75 91506.25 10000.00 26790.00 54716.25 16414.88 71131.13 6 292820.00 219615.00 73205.00 10000.00 26760.00 36445.00 10933.50 47378.50 7 234256.00 175692.00 58564.00 10000.00 13380.00 35184.00 10555.20 45739.20 8 187404.80 140553.60 46851.20 10000.00 0.00 36851.20 11055.36 47906.56 Net Present Value Year Cash Flows Present Value factor@8% Present Value 0 -320000 1.00 -320000.00 1 12519.00 0.93 11591.67 2 -18356.00 0.86 -15737.31 3 17881.50 0.79 14194.91 4 46432.75 0.74 34129.46 5 71131.13 0.68 48410.65 6 47378.50 0.63 29856.49 7 45739.20 0.58 26688.38 8 92906.56 0.54 50194.52 Net Present Value -120671.23 (Year 8 Cash flow includes Salvage Value of the equipment and working capital recovered) As the NPV is negative, the project is not viable.

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