As a CFO of ABC Corporation you have to analyze a proposal for establishing a sm

Question

As a CFO of ABC Corporation you have to analyze a proposal for establishing a small production line of high quality oil filters for general aviation aircraft ABC has a building that was previously used for a research lab, but now is empty because last year the lab was relocated to Arizona The building is suitable for the production line. ABC does not consider selling the building but the corporation can put it for a lease and collect $30,000 per year. The project requires an investment of $1 mln in production machinery. The corporation applies straight-line depreciation to the production machinery over 5 years to a book salvage value of $100,000. ABC anticipates that the machinery can actually be sold in 5 years for $200,000 The revenues and operating expenses related to the production line are presented in Table 1. The project will initially require $350,000 in working capital that will be fully recovered in year 5. The working capital requirements will vary from year to year (see Table 1). Last year the corporation sold some of the relocated lab equipment for $130,000. ABC intends to use the proceeds for the oil filters project In five years the corporation will close down the production line and will concentrate on multiple research projects for NASA The firm's marginal tax rate is 35 percent and the discount rate is 14 percent Calculate NPV and IRR of the project. Should ABC accept or reject the project? Why yes or why not? Would you change your decision if the discount rate were 12%? Why yes or why a. b. c. not?

Explanation / Answer

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A B C D E F 1 Year 0 1 2 3 4 5 2 Capital investment 1,000,000 3 Salavage Value At Year 5 = Salvage Value *(1-Tax rate) 130000 4 Working Capital 350,000 400,000 500000 600000 600000 0 5 Change in WC 350,000 50,000 100,000 100,000 0 -350,000 (Recovery in year 5) 6 Revenues 600,000 720,000 864,000 1,036,800 1,244,160 7 Operating Expenses 300,000 360,000 432,000 518,400 622,080 8 Depreciation=(Capital Investment-Book Value)/5 180,000 180,000 180,000 180,000 180,000 Depreciation = (1,000,000 - 100,000)/5 9 Pretax Profit = Revnue -Operating Expenses - Depreciation 120,000 180,000 252,000 338,400 442,080 10 TAX= Pretax Profit *35% 42000 63000 88200 118440 154728 11 Profit After Tax 78,000 117,000 163,800 219,960 287,352 12 Cash Flow From Operations= Profit after Tax + Depreciation- Change in Working Capital 208,000 197,000 243,800 399,960 817,352 13 Opportunity Cost(Proceeds from sale of old equipment) 130000 14 Net Cash Flow(For Year 1 Invetsment+Change in NWC + Opportunity Cost) -1,480,000 208,000 197,000 243,800 399,960 947,352 Year 5 Cash flow salvage value is added 15 Discount Rate 14% NPV using Excel Formula =NPBV(A15,B14:F14)+A14 -252,567.33 IRR using Excel formula =IRR(A14:F14) 8.27% b) the Project should be rejected because NPV is negative and it will reduce value of the firm c) No the decision wouldnot change at 12% because it is higher than IRR of 8.27% So it should be rejecetd

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