(Comprehensive problem) The Shome Corporation, a firm in the 34 percent marginal
ID: 2766015 • Letter: #
Question
(Comprehensive problem) The Shome Corporation, a firm in the 34 percent marginal tax bracket with a 15 percent required rate of return or cost of capital, is considering a new project. The project involves the introduction of a new product. This project is expected to last 5 years and then, because this is somewhat of a fad product, be terminated. Given the following information, determine the free cash flows associated with the project, the project’s net present value, the profitability index, and the internal rate of return. Apply the appropriate decision criteria.
Cost Of new plant and equipment
$6,900,000
Shipping and installation costs
$ 100,000
Unit Sales
Year
Units sold
1
80,000
2
100,000
3
120,000
4
70,000
5
70,000
Sales price per unit
$250/unit in years 1 through 4,$200/unit in year 5
Variable cost per unit
$130/units
Annual fixed costs
$300,000 per year in year 1-5
Working-capital requirements
There will be an initial working-capital requirement of $100,000 just to get production started. For each year , the total investment in net working capital will be equal to 10 percent of the dollar value of sales for that year. Thus, the investment in working capital will increase during years 1 through 3, then decrease in year 4. Finally, all working capital is liquidated at the termination of the project at the end of year 5.
The Depreciation method
Use the simplified straight-line method over 5 years. Assume that the plant and equipment will have no salvage value after 5 years
Cost Of new plant and equipment
$6,900,000
Shipping and installation costs
$ 100,000
Unit Sales
Year
Units sold
1
80,000
2
100,000
3
120,000
4
70,000
5
70,000
Sales price per unit
$250/unit in years 1 through 4,$200/unit in year 5
Variable cost per unit
$130/units
Annual fixed costs
$300,000 per year in year 1-5
Working-capital requirements
There will be an initial working-capital requirement of $100,000 just to get production started. For each year , the total investment in net working capital will be equal to 10 percent of the dollar value of sales for that year. Thus, the investment in working capital will increase during years 1 through 3, then decrease in year 4. Finally, all working capital is liquidated at the termination of the project at the end of year 5.
The Depreciation method
Use the simplified straight-line method over 5 years. Assume that the plant and equipment will have no salvage value after 5 years
Explanation / Answer
Particulars
0
1
2
3
4
5
Total
Sales
80000*250
100000*250
120000*250
70000*200
70000*200
20000000
25000000
30000000
14000000
14000000
(-)Variable cost
80000*130
100000*130
120000*130
70000*130
70000*130
10400000
13000000
15600000
9100000
9100000
Contribution
9600000
12000000
14400000
4900000
4900000
(-)Fixed cost
300000
300000
300000
300000
300000
(-)Depre on Plant
1380000
1380000
1380000
1380000
1380000
6900000/5
Earning before tax
7920000
10320000
12720000
3220000
3220000
(-)Tax @34%
2692800
3508800
4324800
1094800
1094800
EAT
5227200
6811200
8395200
2125200
2125200
(+)Depre on Plant
1380000
1380000
1380000
1380000
1380000
Free cash flow
6607200
8191200
9775200
3505200
3505200
(-)Working capital
100000
2000000
2500000
3000000
1400000
1400000
(+)Working capital
10400000
(-) Shipping cost
100000
(-)Initial Investment
6900000
Total cash flow
-7100000
4607200
5691200
6775200
2105200
12505200
PVF @15%
0.869565217
0.756143667
0.657516232
0.5717532
0.4971767
0.4323276
Net Present value
-6173913.04
3483705.104
3742056.382
3873742.6
1046656.5
5406343.1
11378591
Profitability index = PV of future cash flow/Initial investment
= 17352504/6900000
= 2.515
Internal rate of return (IRR) is a discount rate that makes the net present value (NPV) of all cash flows from a particular project equal to zero.
We have to find IRR by assuming different discount rate by Trial and error method
Take Discount rate = 70.9684%
Particulars
0
1
2
3
4
5
Total
Total cash flow
-7100000
4607200
5691200
6775200
2105200
12505200
PVF @70.9684%
0.5849034
0.342111998
0.200102474
0.117041
0.068457
0.040041
Net Present value
-4152814.2
1576178.397
1138823.199
792973.6
144116.6
500720.7
0
Particulars
0
1
2
3
4
5
Total
Sales
80000*250
100000*250
120000*250
70000*200
70000*200
20000000
25000000
30000000
14000000
14000000
(-)Variable cost
80000*130
100000*130
120000*130
70000*130
70000*130
10400000
13000000
15600000
9100000
9100000
Contribution
9600000
12000000
14400000
4900000
4900000
(-)Fixed cost
300000
300000
300000
300000
300000
(-)Depre on Plant
1380000
1380000
1380000
1380000
1380000
6900000/5
Earning before tax
7920000
10320000
12720000
3220000
3220000
(-)Tax @34%
2692800
3508800
4324800
1094800
1094800
EAT
5227200
6811200
8395200
2125200
2125200
(+)Depre on Plant
1380000
1380000
1380000
1380000
1380000
Free cash flow
6607200
8191200
9775200
3505200
3505200
(-)Working capital
100000
2000000
2500000
3000000
1400000
1400000
(+)Working capital
10400000
(-) Shipping cost
100000
(-)Initial Investment
6900000
Total cash flow
-7100000
4607200
5691200
6775200
2105200
12505200
PVF @15%
0.869565217
0.756143667
0.657516232
0.5717532
0.4971767
0.4323276
Net Present value
-6173913.04
3483705.104
3742056.382
3873742.6
1046656.5
5406343.1
11378591
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