Capital Budgeting Exercise 2 Your company has spent $250,000 on research to deve
ID: 2741309 • Letter: C
Question
Capital Budgeting Exercise 2
Your company has spent $250,000 on research to develop a new computer game. The firm is planning to spend $1,400,000 on a machine to produce the new game. Shipping and installation costs for the new machine total $200,000 and these costs will be capitalized and depreciated together with the cost of the machine. The machine will be used for 3 years, has a $200,000 estimated resale value at the end of three years, and will be depreciated straight line over 4 years. Revenue from the new game is expected to be $1,200,000 per year, with costs of $500,000 per year. The firm has a tax rate of 35 percent, a cost of capital (discount rate) of 6 percent, and it expects net working capital (NWC) to increase by $150,000 at the beginning of the project. This investment in NWC will be wholly recouped at the end of the project. .
Complete the table below.
In the second table below calculate the Net Present Value (NPV) of the project.
Calculate the Profitability Index (PI) of the project.
Is the Internal Rate of Return (IRR) of the project greater than, equal to, or less than the cost of capital (discount rate)?
Should your company proceed with this project? Explain based on the decision criteria for NPV, PI, and IRR.
Year
0
1
2
3
Revenue
Costs
Depreciation
EBIT
Taxes
Net Income
Operating Cash Flow
Change in Net Operating Working Capital
Change in Gross Fixed Assets
Total Free Cash Flow
Net Present Value
Profitability Index
Internal Rate of Return >, =, or < the cost of capital (discount rate)?
Proceed with the project? Explain.
I posted this question before, but it was not completed.
Year
0
1
2
3
Revenue
Costs
Depreciation
EBIT
Taxes
Net Income
Operating Cash Flow
Change in Net Operating Working Capital
Change in Gross Fixed Assets
Total Free Cash Flow
Explanation / Answer
Initial Outlay:
Fixed Capital Investment : - $16,00,000
Working Capital Investment : - $150,000Total Initial outlay : $1,750,000
After Tax Operating Cash Flows: (All figures in $)
Year
0
1
2
3
Sales
1,200,000
1,200,000
1,200,000
1,200,000
Cash operating expenses
500,000
500,000
500,000
500,000
Depreciation
350,000
350,000
350,000
350,000
EBIT
350.000
350,000
350,000
350,000
Taxes
122,500
122,500
122,500
122,500
Net Income
227,500
227,500
227,500
227,500
Add back : Depreciation
350000
350000
350000
350000
Operating Cash Flow after tax
577,500
577,500
577,500
577,500
Terminal Year after tax cash flows:
Book value of asset at the end of 3rd year = $350,000
Market value of asset at the end of 3rd year : $200,000
After tax salvage value = 200,000 - .35 (200,000 – 350,000) = $2,52,500
Return of Net Working Capital = $ 150,000
Terminal year Cash Flow = $252,500 + $150,000 = $402,500
Total after tax cash flows:
Year
0
1
2
3
577,500
577,500
577,500 + 402500
Given the discount rate of 6%
NPV = 131,611 ( positive)
IRR = 9.66% (greater than discount rate which was 6%)
Profitability Index = 1.075 ( greater than 1)
Based on all three methods, the company should accept the project
Year
0
1
2
3
Sales
1,200,000
1,200,000
1,200,000
1,200,000
Cash operating expenses
500,000
500,000
500,000
500,000
Depreciation
350,000
350,000
350,000
350,000
EBIT
350.000
350,000
350,000
350,000
Taxes
122,500
122,500
122,500
122,500
Net Income
227,500
227,500
227,500
227,500
Add back : Depreciation
350000
350000
350000
350000
Operating Cash Flow after tax
577,500
577,500
577,500
577,500
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