Capital budgeting The company is going to analyse a new investment project which
ID: 2788385 • Letter: C
Question
Capital budgeting The company is going to analyse a new investment project which has the following characteristics:
Unit price $5.00
Annual unit sales 40,000
Variable cost per unit $2.25
Investment into new machinery (t=0) $300,000
Investment in working capital $50,000 (fully recovered at the end of project)
Project life 6 years
Annual depreciation $40,000
Market value of machinery (t=6) 30,000
Tax rate 40 % (the same for profits and capital gains)
Required rate of return (WACC) 10 %
Marketing research expense $11,000 (the research was conducted earlier this year)
Questions:
Find the project cash flows (initial investment, operating cash flows each year and terminal cash flow)
Evaluate the project NPV
Should the company invest into such project? Explain.
Explanation / Answer
Answer
Initial Cash Flow
Machinery Cost=300000 $
Working Capital= 50000$
Total = 350000 $
Operating Cash Flow Each Year :
Annual Sales = 40000*5 200000$
Less : Variable Cost :2.25*40000 90000$
Operating Profit Before Tax 110000 $
Operating Profit After Tax 110000(1-.40) = 66000 $
Add: Tax Saving due to depreciation 40000*.40 = 16000 $
So Net Annual Cash Flow = 66000+16000 = 82000$
Terminal Value :
Book Value Of Machinery at t 6 = 300000-240000 = 60000 $
Machinery Sale Value : 30000 $
So Machinery will be sold at 30000 $ loss and its tax saving on capital loss = 30000*.40 = 12000 $
So Total Terminal Value of Machinery become = 30000+12000 = 42000 $
And Working Capital Recovered back = 50000 $
Total = 92000 $
Now Evaluation of NPV :
Since Net Present Value is positive the project should be accepted.
Cash Flows Year Cash Flow ($) PVF @ 10 % PVCF ($) Inintial Investment 0 (350000) 1 (350000) Annual Cash Flows 1 to 6 82000 4.35 356700 Terminal Value 6 92000 .705 64860 Net Present Value 71560