You are considering building a factory. The initial cost to build the factory is

Question

You are considering building a factory. The initial cost to build the factory is $3 billion, the factory will last 5 years and have a salvage value of $1 billion. You plan to use straight line depreciation and depreciate the factory towards a book value of $0.4 billion. Sales from the factory are expected to be $2 billion each year for the next 5 years and costs (other than depreciation) are 60% of revenues. Additional capital expenditures of $100 million will be required at the end of each of the next 5-years (i.e., at t=1,2,3,4 and 5) . Inventories and A/P will immediately rise by $500 million and $100 million respectively and remain at these levels until returning to back to original levels at the end of the project (t=5). A/R will rise by $400 million after the 1st year (i.e., at t=1) and remain at that level until falling back to original levels at the end of the project’s life (t=5). If the WACC for the project is 15%, the marginal tax rate is 40% and the capital gains tax rate is 40%. a) What is the project’s NPV? b) Suppose it turns out that you are using an existing structure that you built 5 years ago for $550 million, but that still required the $3 billion to adapt for current purposes. In addition, you can rent the building for the equivalent of $100 million FCFF each year. How does this affect your decision?

Explanation / Answer

Part - A

Calculation of Net Present Value

Computation of Initial Cash Outfow

Initial Investmen = 3000 million

Less : Working Capital =(800 million)

(inventory+account Receivable-

account Payable =500+400-100) -----------------

2200 Million

Net Present Value = Discounted Cash Inflow - Discounted Cash Outflow

=2577.82 million - 2200 million

=377.82 million $

Part- B

Initial Investment ( Cssh outflow ) =2750 million (2200+550)

Cash Inflow =2577.82+335.22(100*3.3522)(Present Value Factor)

=2913.04 Million

Net Present Value = 2913.04 - 2750

=163.04 million

Decision : Project accepted because Positive Net Present Value but NPV decreases on214.78 Million (377.82-163.04).

Particulars Amount in Million A.Sales 2000 B.Cost @ 60% (1200) C.Contribution 800 D.Depreciation (400) E.Additional Capital Expenditure (100) F.Profit before Tax 300 G.Tax @ 40% (120) H.Cash Flow After Tax 180 I.Add:Depreciation (400+100) 500 J.Cash Flow After Tax and Depreciation 680 K.Present Value @ 15% Annuity Factir for 5 Years 3.3522 L.Present Value of Cash Inflow (J*K) 2279.50 M.Salvage Value (1000*0.6(1-Capital Gain tax)*0.4972(PF Factor 5th year 298.32 N.Total Cash Inflow 2577.82

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