Your firm is considering introducing a new version of an old product, this will

Question

Your firm is considering introducing a new version of an old product, this will require a large investment. Given is information on the new investment.
? Cost of required equipment: $12,000,000
• The equipment (and project) will last for 5 years
• Straight line depreciation will be used.
• The expected salvage value after 5 years is $2,000,000
? Revenues per year: $10,000,000
? Expected reduction in sales of existing product per year: $1,000,000
? Cost of raw materials per year: $4,000,000
? Cost of additional workers per year: $1,000,000
? Necessary investment in additional Net Working Capital over the life of the project: $1,000,000
? Corporate tax rate: 35%

Assume that the appropriate discount rate for this project is 12%. The NPV of the cash flows that this project will generate is: A.  $1.62 million B.  $0.71 million C.  $-1.74 million D.  $-0.54 million Your firm is considering introducing a new version of an old product, this will require a large investment. Given is information on the new investment.
? Cost of required equipment: $12,000,000
• The equipment (and project) will last for 5 years
• Straight line depreciation will be used.
• The expected salvage value after 5 years is $2,000,000
? Revenues per year: $10,000,000
? Expected reduction in sales of existing product per year: $1,000,000
? Cost of raw materials per year: $4,000,000
? Cost of additional workers per year: $1,000,000
? Necessary investment in additional Net Working Capital over the life of the project: $1,000,000
? Corporate tax rate: 35%

Assume that the appropriate discount rate for this project is 12%. The NPV of the cash flows that this project will generate is: A.  $1.62 million B.  $0.71 million C.  $-1.74 million D.  $-0.54 million

Explanation / Answer

Answer is B

Time line 0 1 2 3 4 5 Cost of equipment -12000000 Installation cost 0 Total investment in new machine -12000000 Net working capital -1000000 =Initial Investment outlay -13000000 Savings 10000000 10000000 10000000 10000000 10000000 -Depreciation Cost of equipment/5 -2400000 -2400000 -2400000 -2400000 -2400000 -reduction in sales -1000000 -1000000 -1000000 -1000000 -1000000 -cost of addtnl worker -1000000 -1000000 -1000000 -1000000 -1000000 -Cost of raw material -4000000 -4000000 -4000000 -4000000 -4000000 =pretax cash flow 1600000 1600000 1600000 1600000 1600000 -taxes =(Pretax cash flow)*(1-tax) 1040000 1040000 1040000 1040000 1040000 +Depreciation 2400000 2400000 2400000 2400000 2400000 =after tax operating cash flow 3440000 3440000 3440000 3440000 3440000 Reversal of Net working capital 1000000 Proceeds from sale of assets =selling price*(1 - tax rate) 1300000 Terminal year non operating cash flows 2300000 Total Cash flow for the period -13000000 3440000 3440000 3440000 3440000 5740000 Discount factor =(1+discount rate)^n 1 1.12 1.2544 1.404928 1.573519 1.762342 Discount rate= 12% Discounted cash flows -13000000 3071428.571 2742347 2448524 2186182 3257030 NPV= Sum of discounted cash flows 705511.9

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