You are evaluating a project for your company. You estimate the sales price to b

Question

You are evaluating a project for your company. You estimate the sales price to be $640 per unit and sales volume to be 3,400 units in year 1; 4,400 units in year 2; and 2,900 units in year 3. The project has a three-year life. Variable costs amount to $440 per unit and fixed costs are $270,000 per year. The project requires an initial investment of $395,000 in assets which will be depreciated straight-line to zero over the three-year project life. The actual market value of these assets at the end of year 3 is expected to be $64,000. NWC requirements at the beginning of each year will be approximately 20 percent of the projected sales during the coming year. The tax rate is 30 percent and the required return on the project is 8 percent. What change in NWC occurs at the end of year 1?

$371,200

$128,000

$259,840

$89,600

Please show work so I will know how to solve in future.

Explanation / Answer

it is a problem on capital investment. Money is invested for a period of three years. Initially company has to invest $395,000 to buy the assets. It is cash outflow of period 0. Another cash outflow is working capital investment. Company has to invest working capital equivalent to coming years 20% sales value. Thus requirement of year 1 will be invested in year 0. Then extra requirement if any of year 2 will be invested at the end of year 1. If requirement is less then excess portion of working capital may be withdrawn.

Based on this concept, working capital requrement of each year is shown below:

Statement showing working capital requirement

Note that first years working capital requirement is $435,200. It is introduced at year 0. Second years requirement is $563,200. It is $563,200-$435,200=$128,000 extra. This amount is to be introduced at the end of year 1. Then requirement of year 3 is coming down. So at the end of year 2, $192,000 should be withdrawn. Finally at the end of year 3 full amount of $371,200 will be withdrawn as the project has ended.

Answer: Change in NWC occurs at the end of year 1 is $128,000.

Details Year 0 Year 1 Year 2 Year 3 1. Quantity sold 3,400 4,400 2,900 2. Sale price $640 $640 $640 3. sale value [ 1x2] $2,176,000 $2,816,000 $1,856,000 4. Working capital [20% x row 3] $435,200 $563,200 $371,200 5. Working capital introduced/returned $435,200 $128,000 -$192,000 -371,200

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