ABC Corp. manufactures television sets and computer monitors. The company is con
ID: 2813815 • Letter: A
Question
ABC Corp. manufactures television sets and computer monitors. The company is considering introducing a new 40” flat screen television/monitor. The company’s CFO collected the following information about the proposed product.
(1) The project has an anticipated economic life of 5 years.
(2) The company will have to purchase a new machine to produce the screens. The up-front cost (t = 0) is $4,000,000. The machine will be depreciated on a straight-line basis over 5 years. The company anticipates that the machine will last for five years and then have no salvage value (i.e., salvage/residual value = 0).
(3) If the company goes ahead with the proposed product, it will have to increase inventory by $280,000 and accounts payable by $80,000 at t = 0. At t = 5, the net working capital will be recovered after the project is completed (so, in this example, the company treats an increase in net working capital as an initial investment that is necessary for the project and the liquidation of the increased net working capital as the liquidation of the project asset; rather than projecting an annual change in net working capital as part of operating cash flow).
(4) The screen is expected to generate sales revenue of $2,000,000 the first year; $4,500,000 the second through fourth years and $3,000,000 in the fifth year. Each year the operating costs (excluding depreciation) are expected to equal 50% of sales revenue brought by the new television.
(5) The company’s interest expense each year will be $350,000.
(6) The new screens are expected to reduce the sales of the company’s large screen TV’s by $500,000 per year.
(7) The company’s (annual) after-tax cost of capital is 12%.
(8) The company’s tax rate is 30%.
• The project's initial investment: $4,200,000
• 3rd year expected incremental operating cash flow: $1,465,000
• 5th year expected non-operating incremental cash flow: $200,000
Question: Compute the NPV of the project and determine whether to take on the project.
Explanation / Answer
Computation of the net present value(NPV) of the project.We have,
Step1: Computation of the depreciation expenses per year using straight-line method.We have,
Depreciation expense = ( Value of machine - Salvage value) / Number of years
Depreciation expense = ( 4,000,000 - 0) / 5 = $ 800,000
Step2: Computation of the initial cash outflow.We have,
Initial cash outflow = Cost of machine + Change in net working capital( Increase in inventory - Increase in account payable)
Initial cash outflow = 4,000,000 + ( 280,000 - 80,000) = 4,000,000 + 200,000
Initial cash outflow = $ 4,200,000
Step3: Computation of the present value of free cash flow after taxes.We have,
Less: COGS
(50% of sales revenue)
Total present value of cash inflow = $ 6,032,815
Step4: Computation of the net present value(NPV) of the project.We have,
NPV = Present value of cash inflow - Cash outflow
NPV = 6,032,815 - 4,200,000 = $ 1,832,815
Hence,the net present value of the project shall be $ 1,832,815
Conclusion:
If NPV of the project has positive value.Then, project should be accepted.In this question, the NPV of the project has $ 1,832,815. Therefore, this project should be accepted.
Year 1 2 3 4 5 Sales Revenue 2,000,000 4,500,000 4,500,000 4,500,000 3,000,000Less: COGS
(50% of sales revenue)
1,000,000 2,250,000 2,250,000 2,250,000 1,500,000 Gross profit 1,000,000 2,250,000 2,250,000 2,250,000 1,500,000 Less: Depreciation 800,000 800,000 800,000 800,000 800,000 Less: Interest expense 350,000 350,000 350,000 350,000 350,000 Operating profit - 150,000 1,100,000 1,100,000 1,100,000 350,000 Add: Recovery of NWC 200,000 Profit before taxes - 150,000 1,100,000 1,100,000 1,100,000 550,000 Less: tax expense(30%) 0 330,000 330,000 330,000 165,000 Profit after taxes - 150,000 1,430,000 1,430,000 1,430,000 385,000 Add: Depreciation 800,000 800,000 800,000 800,000 800,000 Free cash flow after taxes 650,000 2,230,000 2,230,000 2,230,000 1,185,000 PVF(12%) 0.892 0.797 0.712 0.635 0.567 Present value of free cash flow after taxes 579,800 1,777,310 1,587,760 1,416,050 671,895