MacroHard considers selling a Virtual Reality device set HoloGlobe. The manageme
ID: 2735990 • Letter: M
Question
MacroHard considers selling a Virtual Reality device set HoloGlobe. The management anticipates that new system will have the first year revenues of $500,000 K with subsequent annual revenue growth of 20%. Operating costs are 70% of revenues.
The project requires $600 Mil investment in equipment, which will have a five year anticipated life and will be depreciated using five year MACRS depreciation method toward a zero book value (five year MACRS official depreciation rates are given below - it does require 6 years, this is not a typo!). However, the company will be able to sell the equipment on the after-market at the end of year 5 for 20% of its original cost. The company requires an 12% rate of return from its investment and faces a 35% tax rate (overall the company is profitable). In addition to capital investment, the project requires an outlay of net working capital equal to 20% of revenues in the coming year. I.e., at time 0 (beginning of year 1) net working capital requirement is $100,000 K and will grow in subsequent years. All NWC will be recovered after the project's end.
a) Calculate the NPV and IRR for the project. Should the company undertake the project? (see chapter 2 for details)
b) The marketing and operations department disagree with current projections for operating costs, first year revenues and revenue growth . Considering one factor at a time, at what level of operating costs, initial revenues, and revenues growth (decline) the project will break-even (NPV=0)? (see chapter 3 for details)
c) Looking at percentage difference between the predicted level and critical (break-even) level of each of the three factors, which of them is the most critical?
Given MACRS 5 Year Depreciation Asset Book Value Investment cost (today) $ (600,000,000) Year 1 20.00% Project Life 5 years Year 2 32.00% Net Working Capital 20.00% of revenues Year 3 19.20% Year 1 revenues $ 500,000,000 Year 4 11.52% Operating costs 70.00% of revenues Year 5 11.52% After-market (salvage) value 20% of initial investment Year 6 5.76% Revenue annual growth 20.00% Required rate of return 12.00% Tax rate 35% Solution Year Cash flow estimation 0 1 2 3 4 5 Investment $ (600,000,000) Revenues 500,000,000 600,000,000 720,000,000 864,000,000 1,036,800,000 Operating costs 350,000,000 420,000,000 504,000,000 604,800,000 725,760,000 EBITDA $ 150,000,000 $ 180,000,000 $ 216,000,000 $ 259,200,000 $ 311,040,000 Less: Depreciation 120,000,000 Incremental EBIT $ 30,000,000 $ 180,000,000 $ 216,000,000 $ 259,200,000 $ 311,040,000 Less: Taxes 10,500,000 63,000,000 75,600,000 90,720,000 108,864,000 NOPAT Plus: Depreciation Change in NWC After-Tax Cash from Asset Sale FFCF NPV IRR Analysis b) The marketing and operations department disagree with current projections for operating costs, first year revenues and revenue growth . Considering one factor at a time, at what level of operating costs, initial revenues, and revenues growth the project will break-even (NPV=0)? (see chapter 3 for details) Base case Break-even Operating costs (% of revenues) 70.00% Year 1 revenues $ 500,000,000 Revenues growth (decline) 20.00% Cash flow estimation 0 1 2 3 4 5 Investment $ (600,000,000) Revenues Operating costs EBITDA Less: Depreciation Incremental EBIT Less: Taxes NOPAT Plus: Depreciation Change in NWC Cash from Asset Sale FFCF NPV IRR Looking at percentage difference between the predicted level and critical (break-even) level of each of the three factors, which of them is the most critical? Base case Break-even Difference (%) Operating costs (% of revenues) 70.00% Year 1 revenues $ 500,000,000 Revenues growth 20.00% Your answer.Explanation / Answer
Year 0 Year 1 Year 2 Year 3 Year 4 Year 5 Inintial Investment $ (600,000) Net Working Capital Reqt $ (100,000) Revenue $ 500,000 $ 600,000 $ 720,000 $ 864,000 $ 1,036,800 70.00% Operating costs $ (350,000) $ (420,000) $ (504,000) $ (604,800) $ (725,760) Depreciation $ (120,000) $ (192,000) $ (115,200) $ (69,120) $ (69,120) 20.00% 32.00% 19.20% 11.52% 11.52% Salvage Value $ 120,000 Profit Before Tax $ 30,000 $ (12,000) $ 100,800 $ 190,080 $ 361,920 Tax @35% $ (10,500) $ - $ (35,280) $ (66,528) $ (126,672) Profit After tax $ 19,500 $ (12,000) $ 65,520 $ 123,552 $ 235,248 Add : Depreciation $ 120,000 $ 192,000 $ 115,200 $ 69,120 $ 69,120 Less: Incremental Net Working Capital $ - $ (20,000) $ (44,000) $ (72,800) $ (107,360) Working Capital $ 100,000 Cash Flow $ (700,000) $ 139,500 $ 160,000 $ 136,720 $ 119,872 $ 297,008 Discounted Cash Flow (@12%) $ (700,000) $ 124,554 $ 127,551 $ 97,315 $ 76,181 $ 168,530 NPV $ (105,870) IRR 6.27% Case 1 (At lower Operating Cost) 1 2 3 4 5 Year 0 Year 1 Year 2 Year 3 Year 4 Year 5 Inintial Investment $ (600,000) Net Working Capital Reqt $ (100,000) Revenue $ 500,000 $ 600,000 $ 720,000 $ 864,000 $ 1,036,800 63.87% Operating Cost @63.87% $ (319,370) $ (383,244) $ (459,893) $ (551,871) $ (662,246) Depreciation $ (120,000) $ (192,000) $ (115,200) $ (69,120) $ (69,120) Salvage Value $ 120,000 Profit Before Tax $ 60,630 $ 24,756 $ 144,907 $ 243,009 $ 425,434 Tax @35% $ (21,221) $ (8,665) $ (50,718) $ (85,053) $ (148,902) Profit After tax $ 39,410 $ 16,091 $ 94,190 $ 157,956 $ 276,532 Add : Depreciation $ 120,000 $ 192,000 $ 115,200 $ 69,120 $ 69,120 Less: Incremental Net Working Capital $ - $ (20,000) $ (44,000) $ (72,800) $ (107,360) Working Capital $ 100,000 Cash Flow $ (700,000) $ 159,410 $ 188,091 $ 165,390 $ 154,276 $ 338,292 Discounted Cash Flow (@12%) $ (700,000) $ 142,330 $ 149,945 $ 117,721 $ 98,045 $ 191,956 NPV $ (3) Operating Cost @63.87% Case 2 (At higher first year revenue) 1 2 3 4 5 Year 0 Year 1 Year 2 Year 3 Year 4 Year 5 Inintial Investment $ (600,000) Net Working Capital Reqt $ (100,000) Revenue (griwth at 20%) $ 544,250 $ 653,100 $ 783,720 $ 940,464 $ 1,128,557 70.00% Operating Cost @63.87% $ (380,975) $ (457,170) $ (548,604) $ (658,325) $ (789,990) Depreciation $ (120,000) $ (192,000) $ (115,200) $ (69,120) $ (69,120) Salvage Value $ 120,000 Profit Before Tax $ 43,275 $ 3,930 $ 119,916 $ 213,019 $ 389,447 Tax @35% $ (15,146) $ (1,376) $ (41,971) $ (74,557) $ (136,306) Profit After tax $ 28,129 $ 2,555 $ 77,945 $ 138,462 $ 253,141 Add : Depreciation $ 120,000 $ 192,000 $ 115,200 $ 69,120 $ 69,120 Less: Incremental Net Working Capital $ (8,850) $ (30,620) $ (56,744) $ (88,093) $ (125,711) Working Capital $ 100,000 Cash Flow $ (700,000) $ 139,279 $ 163,935 $ 136,401 $ 119,490 $ 296,549 Discounted Cash Flow (@12%) $ (700,000) $ 124,356 $ 130,688 $ 97,088 $ 75,938 $ 168,270 NPV $ (103,661) First Year Revenue should be $ 544,250 Case 3 (Revenue Growth) 1 2 3 4 5 Year 0 Year 1 Year 2 Year 3 Year 4 Year 5 Inintial Investment $ (600,000) Net Working Capital Reqt $ (100,000) 24.77% Revenue (Growth at 500000 $ 623,850 $ 778,378 $ 971,182 $ 1,211,744 70.00% Operating Cost @63.87% $ (350,000) $ (420,000) $ (504,000) $ (604,800) $ (725,760) Depreciation $ (120,000) $ (192,000) $ (115,200) $ (69,120) $ (69,120) Salvage Value $ 120,000 Profit Before Tax $ 30,000 $ 11,850 $ 159,178 $ 297,262 $ 536,864 Tax @35% $ (10,500) $ (4,148) $ (55,712) $ (104,042) $ (187,902) Profit After tax $ 19,500 $ 7,703 $ 103,465 $ 193,220 $ 348,961 Add : Depreciation $ 120,000 $ 192,000 $ 115,200 $ 69,120 $ 69,120 Less: Incremental Net Working Capital $ - $ (24,770) $ (55,676) $ (94,236) $ (142,349) Working Capital $ 100,000 Cash Flow $ (700,000) $ 139,500 $ 174,933 $ 162,990 $ 168,104 $ 375,733 Discounted Cash Flow (@12%) $ (700,000) $ 124,554 $ 139,455 $ 116,013 $ 106,833 $ 213,201 NPV $ 55 Revenue Growth at 24.77%
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