Revenues generated by a new fad product are forecast as follows: $60,000 in year

Question

Revenues generated by a new fad product are forecast as follows: $60,000 in year one, $40,000 in year two, $30,000 in year three, $10,000 in year four and $0 in each year after. Expenses are expected to be 30% of revenues, and working capital required in each year is expected to be 10% of revenues in the following year. The product requires an immediate investment of $81,000 in plant and equipment. a) What is the initial investment in the product? Remember working capital. b) If the plant and equipment are depreciated over 4 years to a salvage value of zero using straight-line depreciation, and the firm’s tax rate is 20%, what are the project cash flows in each year? Assume the plant and equipment are worthless at the end of 4 years. c) If the opportunity cost of capital is 10%, what is the project's NPV?

Explanation / Answer

a) Year 1 Revenues 60000 Less Expenses - 30% 18000 Working capital - 10% of following month revenue 4000 Capital expenditure 81000 Initial investment -43000 b) Year 1 Year 2 Year 3 Year 4 Revenues 60000 40000 30000 10000 Less Expenses - 30% 18000 12000 9000 3000 Depriciation 20250 20250 20250 20250 Net Income before tax 21750 7750 750 -13250 Tax @ 20% 4350 1550 150 0 Net Income 17400 6200 600 -13250 Capital expenditure 81000 depriciation SLM pa ( 81000/4) 20250 b) Cash Flow Year 1 Year 2 Year 3 Year 4 Net Income 17400 6200 600 -13250 Add depriciation 20250 20250 20250 20250 cash flow 37650 26450 20850 7000 c) Discounting factor @ 10% 1.1 1.21 1.331 1.4641 Net present value 34227.27 21859.5 15664.91 4781.094 76532.78 NPV = Total NPV - Initial investment          = 76532.78 - 43000          = 33532.78

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