Incremental Cash Flows and Project Evaluation Classic Cars is considering expand
ID: 2761759 • Letter: I
Question
Incremental Cash Flows and Project Evaluation
Classic Cars is considering expanding its product line by manufacturing classic Mustangs. The necessaryequipment will cost $4,000,000 and installation costs will be $50,000. The equipment will bedepreciated using a 5 year MACRS life with depreciation rates of 20%, 32%, 19.2%, 11.52% and 11.52%in Years 1-5, respectively. Projected sales in units will be 300/year for each of the next 5 years. Thesales price is projected at $27,000 per car and variable costs at $18,000 per car. Fixed costs of the firmwill increase by $1,200,000 per year. The company would anticipate selling the equipment for $500,000at the end of year five. To support the new operation, the company anticipates having to increase itsnet working capital by $600,000 at the beginning of the project, but will no longer need to maintain thehigher level of working capital once it sells the equipment. If the company’s tax rate on ordinary incomeis 35%, its tax rate on capital gains is 15%, and its WACC is 12%, should the company do the project?
Explanation / Answer
Year/Description of cashflow 0 1 2 3 4 5 Cost of equipment (A) -4000000 Cost of installation (B) -50000 Depriciation tax shield=Rate of depriciation*Cost of equipment©*Tax Rate © 280000 448000 268800 161280 161280 Operating Income after tax =(Quantity*(SP-CP)-Fixed cost)*(1-Tax Rate)=(300*(27000-18000)-1200000)*(1-0.35) (D) 975000 975000 975000 975000 975000 Working capital (E) -600000 600000 Income from Salvage value=(Sales Price-Book value after depriciation)*(1-Capital gain Tax Rate)=(500000-230400)*(1-0.15) (F) 229160 Cash Flow=A+B+C+D+E+F -4650000 1255000 1423000 1243800 1136280 1965440 PV@12% -4650000 1120536 1134407 885312.3 722126.5 1115243 NPV=Sum of all cash flow 327624.8 Yes the company should take up the project as the NPV is positive. Book Value=(100-20-32-19.2-11.52-11.52)*4000000/100 230400