Academic Integrity: tutoring, explanations, and feedback — we don’t complete graded work or submit on a student’s behalf.

RSM Co is considering a project which will require the purchase of $2.7 million

ID: 2798248 • Letter: R

Question

RSM Co is considering a project which will require the purchase of $2.7 million in new equipment. The equipment will be depreciated straight-line to a book value of $1 million over the 5-year life of the project. Annual sales from this project are estimated at $2,950,000. The variable cost is 40% of the annual sales and there is an annual fixed cost of $200,000. Sway's Back Store will sell the equipment at the end of the project for 30% of its original cost. New net working capital equal to 15% of sales will be required to support the project. All of the new net working capital will be recouped at the end of the project. The firm’s WACC is 12% per year. The tax rate is 40%.

If annual sales is changed to $1,800,000, what is the project’s NPV. assuming every else the same? What is the sensitivity of NPV to annual sales?

Please answer without using Excel. Thank you.

Explanation / Answer

Annual depreciation = (2.7-1)/ 5= 0.34 million

Tax saving on depreciation = 0.136 m

Operating profit before tax = Sales - Costs = 2950000- 40%*2950000 -200000 = 1570000

Operating profit post tax = 1570000*60% = 942000

Sale proceeds of equipment in year 5 = 30%*2700000 = 810,000

Tax saving on Capital loss in year 5= 40%*(810000-1000000) = 76000

Working capital requirement = 15%*2950000 = 442500

The Cash flow table is as below

NPV = 1078000/1.12^1 +1078000/1.12^2+ 1078000/1.12^3+ 1078000/1.12^4+ 2406500/1.12^5 - 3142500

= $1,497,275.32

If annual sales changed to 1800,000, the operating profit post tax will be 528000. Working capital will be 270000

The new cash flow statement will be

NPV will be =

664000/1.12^1 +664000/1.12^2+ 664000/1.12^3+ 664000/1.12^4+ 1820000/1.12^5 - 2970000

= $79516.84

NPV sensitivity = change in NPV/ change in sales

=

= 1.23

Year Initial cost Depreciation tax saving Working capital Operating cash flows post tax Sale of equipment+ tax saving Net Cash flows 0 (2,700,000.00) -442500 (3,142,500.00) 1 136000 942000    1,078,000.00 2 136000 942000    1,078,000.00 3 136000 942000    1,078,000.00 4 136000 942000    1,078,000.00 5 136000 442500 942000 886000    2,406,500.00