Revenues generated by a new fad product are forecast as follows: Year Revenues 1

Question

Revenues generated by a new fad product are forecast as follows: Year Revenues 1 $46,000 2 30,000 3 20,000 4 10,000 Thereafter 0 Expenses are expected to be 50% of revenues, and working capital required in each year is expected to be 30% of revenues in the following year. The product requires an immediate investment of $51,000 in plant and equipment. a. What is the initial investment in the product? Remember working capital. Initial investment $ 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 40%, what are the project cash flows in each year? (Enter your answers in thousands of dollars. Do not round intermediate calculations. Round your answers to 2 decimal places.) Year Cash Flow 1 $ 2 3 4 c. If the opportunity cost of capital is 15%, what is project NPV? (Negative amount should be indicated by a minus sign. Do not round intermediate calculations. Round your answer to 2 decimal places.) NPV $ d. What is project IRR? (Do not round intermediate calculations. Round your answer to 2 decimal places.) IRR %

Explanation / Answer

a   the initial investment in the product :

   Initial Investment    $51000

0 Year initial expenses 50% of Revenue :

   Year 1 46000*50% $23000

year 2 30000*50% $15000

Year3 20000*50% $10000

Year 4 10000*50% $5000

working capital required to be 30% of revenues in following year:

   Year 0 46000*30% $13800

Year 1 30000 *30% * 0.870 $7830   

Year 2 20000*30% *0.756 $4536

Year 3 10000*30% *0.658 $1974   

Total initial investment   $132140   

b. Project cash flows in each year :

year Revenue Depreciation revenue after depreciation Tax Net profit Depreciation Cash inflow

1 46000 12750 33250 13300 19950 12750 32700

2 30000 12750 17250 6900 10350 12750 23100

3 20000 12750 7250 2900 4350 12750 17100

4 10000 12750 -2750 1100 -3850 12750 8900   

Note:- Depreciation = 51000 / 4 = $12750 per year

c. Project NPV :

  Year cash inflow PVF(15%,4year) Present Value

0 -51000 1 -51000

0 -53000 1 -53000

0 -13800 1 -13800

1 -9000 0.870 -7830

2 -6000 0.756 -4536

3 -3000 0.658 -1974

1 32700 0.870 28449

2 23100 0.756 174636

3 17100 0.658 112518

4 8900 0.572 50908

1-4 28140 0.572 16096.08

NPV = present value of cash inflow- present value of cash outflow

=382607.08 - 132140

=250467.08

Note:- We assume that working capital investment realised in end of project useful life from 0 to 3 year = $28140

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