The Volunteer Company (VC) produces electrical switching components and is consi
ID: 2801549 • Letter: T
Question
The Volunteer Company (VC) produces electrical switching components and is considering manufacturing a new component that will require new equipment. The production of this component will require $1,500,000 in net working capital to start and additional net working capital investments each year equal to 15 percent of the projected sales increases for the following year. Total fixed costs are $1,350,000 per year, variable production costs are $225 per unit and the units are priced at $345 each. The equipment needed to begin production has an installed cost of $23,000,000. The equipment is considered to qualify as seven-year MACRS property. In five years, the equipment can be sold for 20 percent of its acquisition cost. VC is in the 35 percent marginal tax bracket and has a required return on all its projects of 18 percent. Based on the preceding project estimates, answer the following questions:
Questions
A. What is the total cash flow of the project for Year 3?
B. What is the NPV of the project?
C. What is the IRR of the project?
D. Should VC begin this project? Explain
Note: An income statement must be prepared for each year. Beginning with the initial cash flow at time zero, the project will require an investment in equipment. The project will also require an investment in net working capital. The Net Working capital investment will be 15 percent of next year’s sales. In this case, it will be Year 1 sales. To assist in your calculation, total sales per year are provided. To calculate depreciation, use the original equipment cost of $23 million times the appropriate MACRS depreciation each year. To determine the after-tax salvage value, the book value of the equipment must be determined. Book value for each year is the purchase price of the equipment ($23 million) less accumulated depreciation. As a check, ending book value for year 5= $5,131,300. Also the capital spending for year 5= (equipment cost x 20% = $4.6 million). After-tax salvage value = $4,600,000 + ($5,131,300 - 4,600,000) (.35) = $4,785,955.
Increase in Net Working Capital for Year 1 = .15($43,815,000 - $37,260,000) =
$983,250; this increase is negative given the increase in sales for year 2. Net Working Capital Increases for the remaining years are positive because sales are declining.
The required cash flow at the beginning of the project:
Equipment purchase price = $23,000,000
Change in Net Working Capital = 1,500,000
Total cash flow (out) = $24,500,000
Use the following format to calculate the total cash flow. Enter the missing values
(Your instructor has provided certain calculations to get you started)
Year
1
2
3
4
5
Ending book value
$19,713,300
$5,131,300
Sales
$37,260,000
$43,815,000
$39,675,000
$33,810,000
$28,980,000
Variable costs
24,300,000
Fixed costs
1,350,000
Depreciation
3,286,700
EBIT
8,323,300
Taxes
2,913,155
Net income
5,410,145
Depreciation
3,286,700
Operating cash flow
$8,696,845
$10,999,945
$9,500,445
$7,771,945
$6,393,365
Net cash flows
Operating cash flow
$8,696,845
Change in NWC
–983,250
621,000
Capital spending
0
0
0
0
4,785,955
Total cash flow
$7,713,595
$11,437,320
MACRS Table to the fourth decimal.
Year
3 Years
5 Years
7 Years
10 Years
15 Years
1
.3333
.2000
.1429
.1000
.0500
2
.4445
.3200
.2449
.1800
.0950
3
.1481
.1920
.1749
.1440
.0855
4
.0741
.1152
.1249
.1152
.0770
5
.1152
.0893
.0922
.0693
6
.0576
.0892
.0737
.0623
7
.0893
.0655
.0590
8
.0446
.0655
.0590
9
.0656
.0591
10
.0655
.0590
11
.0328
.0591
12
.0590
13
.0591
14
.0590
15
.0591
16
.0295
Year
1
2
3
4
5
Ending book value
$19,713,300
$5,131,300
Sales
$37,260,000
$43,815,000
$39,675,000
$33,810,000
$28,980,000
Variable costs
24,300,000
Fixed costs
1,350,000
Depreciation
3,286,700
EBIT
8,323,300
Taxes
2,913,155
Net income
5,410,145
Depreciation
3,286,700
Operating cash flow
$8,696,845
$10,999,945
$9,500,445
$7,771,945
$6,393,365
Net cash flows
Operating cash flow
$8,696,845
Change in NWC
–983,250
621,000
Capital spending
0
0
0
0
4,785,955
Total cash flow
$7,713,595
$11,437,320
Explanation / Answer
Year 1 2 3 4 5 Ending book value $19,713,300 $5,131,300 Sales 37260000 43815000 39675000 33810000 28980000 Variable costs 2,43,00,000 28575000 25875000 22050000 18900000 Fixed costs 13,50,000 13,50,000 13,50,000 13,50,000 13,50,000 Depreciation 32,86,700 5632700 4022700 2872700 2053900 EBIT 83,23,300 82,57,300 84,27,300 75,37,300 66,76,100 Taxes 29,13,155 2890055 2949555 2638055 2336635 Net income 54,10,145 53,67,245 54,77,745 48,99,245 43,39,465 Depreciation 32,86,700 5632700 4022700 2872700 2053900 Operating cash flow 86,96,845 ######### 95,00,445 77,71,945 63,93,365 Net cash flows Operating cash flow 86,96,845 ######### 95,00,445 77,71,945 63,93,365 Change in NWC -983250 6,21,000 879750 724500 258000 Capital spending 0 0 0 0 47,85,955 ` Total cash flow 77,13,595 ######### ######### 84,96,445 ######### PVIF at 18% 0.84746 0.71818 0.60863 0.51579 0.43711 PV at 18% 6536945 8345982 6317707 4382372 4999358 Cumulative PV of cash inflows $ 3,05,82,364 Less: Initial investment $ 2,45,00,000 NPV $ 60,82,364 Answer CALCULATION OF IRR: IRR is that discount rate for which NPV = 0. The value of IRR is to be found out by trial and error till 0 NPV is arrived at. Total cash flow 7713595 11620945 10380195 8496445 11437320 Total PV of inflows NPV PVIF at 28% 0.78125 0.61035 0.46950 0.36115 0.27781 Pv at 28% 6026246 7092862 4873514 3068532 3177417 24238571 -261429 PVIF at 27% 0.78740 0.62000 0.48819 0.38440 0.30268 PV at 27% 6073697 7205000 5067507 3266047 3461829 25074080 574080 IRR lies between 27% and 28%. The exact % can be found out by simple interpoolation as done below. IRR = 27+574080/(574080+261429) = 27.69% Answer ANSWERS: Total cash flow of the project for year 3 = 1,03,80,195 NPV of the project = $ 60,82,364 IRR of the project = 27.69% As the NPV is positive, VC can begin this project.
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