Capital budgeting The company is going to analyse a new investment project which

Question

Capital budgeting The company is going to analyse a new investment project which has the following characteristics:

Unit price                                                                $5.00

Annual unit sales                                                   40,000

Variable cost per unit                                            $2.25

Investment into new machinery (t=0)               $300,000

Investment in working capital                             $50,000       (fully recovered at the end of project)

Project life                                                              6 years

Annual depreciation                                            $40,000

Market value of machinery (t=6)                        30,000

Tax rate 40 %            (the same for profits and capital gains)

Required rate of return (WACC)                         10 %

Marketing research expense $11,000 (the research was conducted earlier this year)

Questions:

Find the project cash flows (initial investment, operating cash flows each year and terminal cash flow)

Evaluate the project NPV

Should the company invest into such project? Explain.

Explanation / Answer

Answer

Initial Cash Flow

Machinery Cost=300000 $

Working Capital= 50000$

Total = 350000 $

Operating Cash Flow Each Year :

Annual Sales = 40000*5 200000$

Less : Variable Cost :2.25*40000 90000$

Operating Profit Before Tax 110000 $

Operating Profit After Tax 110000(1-.40) = 66000 $

Add: Tax Saving due to depreciation 40000*.40 = 16000 $

So Net Annual Cash Flow = 66000+16000 = 82000$

Terminal Value :

Book Value Of Machinery at t 6 = 300000-240000 = 60000 $

Machinery Sale Value : 30000 $

So Machinery will be sold at 30000 $ loss and its tax saving on capital loss = 30000*.40 = 12000 $

So Total Terminal Value of Machinery become = 30000+12000 = 42000 $

And Working Capital Recovered back = 50000 $

Total = 92000 $

Now Evaluation of NPV :

Since Net Present Value is positive the project should be accepted.

Cash Flows Year Cash Flow ($) PVF @ 10 % PVCF ($) Inintial Investment 0 (350000) 1 (350000) Annual Cash Flows 1 to 6 82000 4.35 356700 Terminal Value 6 92000 .705 64860 Net Present Value 71560

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