Cleaner Than Dirt manufactures a variety of household products. The company is c

Question

Cleaner Than Dirt manufactures a variety of household products. The company is considering
introducing a new household cleaning product. The company’s CFO has collected the following
information about the proposed product. (Note: You may or may not need to use all of this information,
use only the information that is relevant.)
• The project has an anticipated economic life of 4 years.
• The company will have to purchase a new machine to produce the product. The machine has an upfront
cost (t = 0) of $2 million. The machine will be depreciated on a straight-line basis over 4 years
(that is, the company’s depreciation expense will be $500,000 in each of the first four years (t = 1, 2,
3, and 4). The company anticipates that the machine will last for four years, and that after four
years, its salvage value will equal zero.
• If the company goes ahead with the proposed product, it will have an effect on the company’s net
operating working capital. At the outset, t = 0, inventory will increase by $140,000 and accounts
payable will increase by $40,000. At t = 4, the net operating working capital will be recovered after
the project is completed.
• The new product is expected to generate sales revenue of $1 million the first year (t = 1), $2 million
the second year (t = 2), $2 million the third year (t = 3), and $1 million the final year (t = 4). Each
year the operating costs (not including depreciation) are expected to equal 50 percent of sales
revenue.
• The company’s interest expense each year will be $100,000.
• The new product is expected to reduce the after-tax cash flows of the company’s existing products
by $250,000 a year (t = 1, 2 , 3, and 4).
• The company’s overall WACC is 10 percent. However, the proposed project is riskier than the
average project for Cleaner Than Dirt; the project’s WACC is estimated to be 12 percent.
• The company’s tax rate is 40 percent.
What is the net present value of the proposed project?

Explanation / Answer

Particulars Year Cash flows PVF @ 12% PV Cost of machine 0 2000000 1 2000000 Working Capital 0 100000 1 100000 Reduction in companys after tax cash flows 1 to 4 250000 3.0373 759325 Present value of cash outflows 2859325 Tax saving on depreciation 1 to 4 200000 3.0373 607460 Sales year 1 net of tax 1 600000 0.8929 535740 Sales year 2 net of tax 2 1200000 0.7972 956640 Sales year 3 net of tax 3 1200000 0.7118 854160 Sales year 4 net of tax 4 600000 0.6355 381300 Working capital 4 100000 0.6355 63550 Present value of cash inflows 3398850 Net Present Value 539525

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