You are financial analyst for a company that is considering supplementing their

Question

You are financial analyst for a company that is considering supplementing their business of workout equipment production and sales with a new product line of supplements. This is a brand new type of venture that comes with considerable risk. You have been given the following details:

• The project timeline is infinite (meaning the plan is to have the product line forever), but you are going to model the first 5 years specifically. Following that, you may assume NCFs will increase by a terminal growth rate of 1.5% annually forever after, which you will use to calculate the terminal value of the project.

• You have been told to expect sales of 300,000$ during the first year followed by 350,000$ during the second, 400,000$ in the third 450,000 in the fourth, 500,000$ in the fifth and final year. During the first three years, you are to assume cost of goods sold to be 45% of sales, while that number decreases to 35% during the final two years.

• The project initially requires the purchase of three new machines. Machine A costs 500,000$, B costs 400,000$, C costs 100,000$. All three machines can be depreciated as 3 year MACRS property classes. An increase in NWC of 200,000$ will be required up front as well, and NWC of 2/3rd of revenues will be required throughout the five years. Since the project is infinite, you do not recover any at the end of 5 years.

• While machines A and B are expected to last for long time, Machine C has a usable lifespan of 3 years before needing to be replaced. At that time, you expect to be able to sell it for 25,000$. You will immediately be required to purchase another identical machine, which cost 100,000$ and can be depreciated as a 3 year property class as well.

• The firm has a tax rate of 21% that will be applied to this project. You may ignore tax carryover losses, if applicable.

• The WACC is 9.8%.

What is the NPV of the project?

Explanation / Answer

Initial Cash Out Flow Machine A $500,000 Machine B $400,000 Machine C $100,000 Increase in NWC(Net Working Capital) $200,000 Total initial cash outflow $1,200,000 Analysis of operating cash flow : N Year 1 2 3 4 5 A Sales Revenue $300,000 $350,000 $400,000 $450,000 $500,000 B=0.45*A from Year1 to 3 & =0.35*A for year 4 &5 Cost of goods sold $135,000 $157,500 $180,000 $157,500 $175,000 C=A-B Before tax operating cash flow $165,000 $192,500 $220,000 $292,500 $325,000 D=C*(1-0.21) After Tax Operating Cash flow $130,350 $152,075 $173,800 $231,075 $256,750 Depreciation Tax Shield E MACRS 3 yearDepreciation Rate 33.33% 44.45% 14.81% 7.41% F=500000*E Depreciation of Machine A $            166,650 $    222,250 $      74,050 $         37,050 G=400000*E Depreciation of Machine B $            133,320 $    177,800 $      59,240 $         29,640 H=1000008E Depreciation of Machine C $              33,330 $      44,450 $      14,810 I Depreciation of replacement machine C $         33,330 $        44,450 J=F+G+H+I Total Depreciation expenses $            333,300 $    444,500 $    148,100 $       100,020 $        44,450 K=J*0.21 Depreciation Tax Shield $              69,993 $      93,345 $      31,101 $         21,004 $          9,335 L=D+K Net Operating Cash flow considering depreciation $200,343 $245,420 $204,901 $252,079 $266,085 Cash flow due to replacement of machine C: M=(100000-33330-44450-14810) Book Value at end of 3 years $        7,410 O Salvage Value at the end of 3 years $25,000 P=O-M Gain on salvage $17,590 Q=P*0.21 Tax on gain $3,694 R=O-Q Net Cash inflow due to salvage of machine C $21,306 S Cash flow due to purchase of replacement ($100,000) T=(2/3)*A Net Working capital required $200,000 $233,333 $266,667 $300,000 $333,333 U Cash flow due to change in Net working capital $0 ($33,333) ($33,333) ($33,333) ($33,333) V=L+R+S+U TOTAL CASH FLOW $200,343 $212,087 $92,874 $218,746 $232,751 SUM PV=V/(1.098^N) Present Value of Cash Flow $            182,462 $    175,917 $      70,159 $       150,498 $     145,841 $ 724,878 W Sum of PV of first 5 years cash flow $            724,878 X=W*1.015 Total Cash Flow in Year 6=232751*1.015 $            735,751 Y=X/(0.098-0.015) Value of Future cash flows in perpetuity in year5 $        8,864,467 Z=Y/(1.098^5) Present Value of Future cash flows from year 6 to infinity $        5,554,449 PVT=W+Z PV of total Cash inflows in future $        6,279,326 NPV=PVT-Initial cash outflow Net Present Value(NPV) of the Project $        5,079,326 (6279326-1200000)

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