Your company has been doing well, reaching $1.06 million in annual earnings, and

Question

Your company has been doing well, reaching $1.06 million in annual earnings, and is considering launching a new product. Designing the new product has already cost $478,000. The company estimates that it will sell 768,000 units per year for $2.95 per unit and variable non-labor cost will be $1.03. Production will end after year 3. New equipment costing $1.09 million will be required. The equipment will be depreciated using the 7-year MACRS schedule. You plan to sell the equipment for book value at the end of year 3. Your current level of working capital is $297,000. The new product will require the working capital to increase to a level of $378,000 immediately, then to $400,000 in year 1, $348,000 in year 2, and finally return to $297,000. Your tax rate is 35%. The discount rate for this project is 10.1%. Do the capital budgeting analysis for this project and calculate its NPV.

Explanation / Answer

NPV = - Year 0 cash flow + Year 1 cash flow /(1+discount rate) + Year 2 cash flow /(1+discount rate) ^ 2 + Year 3 cash flow /(1+discount rate) ^3

NPV = -1171000 + 301980.35/1.101 + 414893.35/1.101^2 + 863845.35/1.101^3

NPV = $ 92795.69

Working

Year 0 Year 1 Year 2 Year 3 Working Capital having [a] 297000 378000 400000 348000 Working Capital Required [b] 378000 400000 348000 297000 Cash flow for working Capital [c = a-b] -81000 -22000 52000 51000 Cash Flow for Equipment [d] -1090000 Depreciation Rate [e] 14.29% 24.49% 17.49% Depreciation Expenses [f = 1090000*e] 155761 266941 190641 Accumulated Depreciation till 3 year [ g = sum of f] 613343 Book Value of Equipment at the end of 3 year [h = 1090000-g] 476657 Salvage Value [i] 476657 Depreciation Tax shield [ g = f*tax rate) 54516.35 93429.35 66724.35 Annual Revenue [k = 768000*2.95] 2265600 2265600 2265600 Annual Cost [l = 768000*1.03] 791040 791040 791040 Net Income before tax [ m = k-l] 1474560 1474560 1474560 Current Annual Earning [n] 1060000 1060000 1060000 Incremental Net Income [o = m-n] 414560 414560 414560 Incremental Net Income after tax [p = o*(1-tax rate)] 269464 269464 269464 Annual Cash Flow [Q = c + d +I +g +p] -1171000.00 301980.35 414893.35 863845.35

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