Revenues generated by a new fad product are forecast as follows: Expenses are ex

Question

Revenues generated by a new fad product are forecast as follows:

Expenses are expected to be 30% of revenues, and working capital required in each year is expected to be 10% of revenues in the following year. The product requires an immediate investment of $81,000 in plant and equipment.

a. What is the initial investment in the product? Remember working capital.

b. If the plant and equipment are depreciated over 4 years to a salvage value of zero using straight-line depreciation, and the firm’s tax rate is 20%, what are the project cash flows in each year? Assume the plant and equipment are worthless at the end of 4 years. (Do not round intermediate calculations.)

c. If the opportunity cost of capital is 10%, what is the project's NPV? (A negative value should be indicated by a minus sign. Do not round intermediate calculations. Round your answer to 2 decimal places.)

d. What is project IRR? (Do not round intermediate calculations. Enter your answer as a percent rounded to 2 decimal places.)

Year Revenues 1 $60,000 2 40,000 3 30,000 4 10,000 Thereafter 0

Explanation / Answer

a. Initial Investment = Investment in asset + working capital Investment

= 81,000 + 10% of 60000 = 81000 + 6000 = 87000

b. Project cash flows in each of the year

c . Calculation of NPV

d. Project IRR

Step - 1 ............ try the NPV at 8%

Step - 2 ......... try with DF = 7%

Step - 3

Now find out IRR using the simple interpolation technique

8% ........ - 785.95

X% ......... 0 ( NPV should be zero at IRR)

7% ...... 809.21

( X - 8 ) / ( 7 - 8 ) = ( 0 - (-785.95) ) / ( 809.21 - (-785.95) )

( X - 8 ) / ( - 1 ) = 785 / 1595.16 =  0.4921

X - 8 = - 0.4921

X = 7.51 % .......... is the IRR of the project

Revenues 60000 40000 30000 10000 (-) Expenses @ 30% of Rev 18000 12000 9000 3000 Profit 42000 28000 21000 7000 (-) Depreciation = 81000 / 4 20250 20250 20250 20250 Profit before tax 21750 7750 750 -13250 (-) Tax @ 20% 4350 1550 150 -2650 Profit after tax 17400 6200 600 -10600 (+) Depreciatin 20250 20250 20250 20250 Cash flow after tax 37650 26450 20850 9650 (+) Release of WC 2000 1000 2000 1000 Total cash in flow 39650 27450 22850 10650

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