Timco is considering the construction of a new retail outlet. The construction c
ID: 1172003 • Letter: T
Question
Timco is considering the construction of a new retail outlet. The construction cost will be 400000. Net working capital will increase by 10000. The depreciation is 10 year MACRS. The new location will increase sales by 90000 and increase costs by 40000 per year. The tax rate is 40%. Assume we can sell the location for 50000 at the end of the tenth year. The WACC is 8%. Find the NPV. Should we buy it? Year zero cash outflow is 400000 (purchase) +10000 (NWC) =410000. Using the MACRS table, depreciation by year is 40000, 72000, 57600, 46080, 36880, 29480, 26200, 26200, 26240, 26200, 13120. 13120 is remaining book value
Year Zero: (410000) Years One through Nine: (?S-?C)*(1-t) +?D*t. This is the after tax operating cash flow and the depreciation tax shield.
Year One: (90000-40000)*(.6) + 40000*.4 = 30000 + 16000 = 46000
Year Two: (90000-40000)*(.6)+ 72000*.4 = 30000 + 28800 = 58800
Year Three: (90000-40000)*(.6)+ 57600*.4= 30000 + 23040 = 53040
Year Four: (90000-40000)*(.6)+ 46080*.4= 30000 + 18432 = 48432
Year Five: (90000-40000)*(.6)+ 36880*.4= 30000 + 14752 = 44752
Year Six: (90000-40000)*(.6)+ 29480*.4= 30000 + 11792 = 41792
Year Seven: (90000-40000)*(.6)+ 26200*.4= 30000 + 10480 = 40480
Year Eight: (90000-40000)*(.6)+ 26200*.4= 30000 + 10480 = 40480
Year Nine: (90000-40000)*(.6)+ 26240*.4= 30000 + 10496 = 40496
In Year Ten we get the operating flow and the tax shield, plus we sell off what we can from the assets and recover our net working capital.
Year Ten: 30000 + 10480 + [(50000-13120)*.6 + 13120] + 10000 = 30000 + 10480 + 35248 + 10000 = 85728. The NPV is (77042.04), so we should not open the new store. To get to an NPV of zero, we would have to raise the net cash inflow by 11481.54 per year or reduce the year zero cash flow by 77042.
?MY QUESTION IS: WHERE IS THE NPV OF (77042.04) COMING FROM? WHAT CASH FLOWS SHOULD I USE TO FIND IT? I UNDERSTAND EVERYTHING ELSE IN THIS PROBLEM.
Explanation / Answer
First of all, NPV refers to Net Present Value which is equal to the Present Value of all the Cash Inflows – Present Value of Cash Outflows
Now, Let’s start with the construction cost of 400,000 – This has to be incurred today , hence already at Present Value and a Cash Outflow
Again Net Working Capital Required of 10,000 is outflow of today i.e. Year 0
Now, the question says that the new location will increase sales by 90,000 and costs by 40,000 per year. Inflow = Sales – Costs. This means that we will be getting 50,000 cash inflows every year, but we will have to pay tax on this income @ 40%, reducing the net cash flows per year to 50,000 – 50,000*40% = 30,000
Depreciation is a non-cash item which doesn’t lead to actual outflow of cash but a reduction in profits. We get tax saving on this amount, since taxes are paid on profits and depreciation reduces profit. So, net inflow taken is tax saved on Depreciation i.e. 40%*Each year’s depreciation
Along with these cash flows, we get working capital + salvage value as well which is taken after deducting Tax
Now, all these amount are occurring at different points in time, hence to bring them to Today’s level, we need to multiply then with the present value factor, given in Present Value table
Year
Cash Flows
PVF@8%
PV
1
46000
0.926
42596
2
58800
0.857
50391.6
3
53040
0.794
42113.76
4
48432
0.735
35597.52
5
44752
0.681
30476.112
6
41792
0.630
26328.96
7
40480
0.583
23599.84
8
40480
0.540
21859.2
9
40496
0.500
20248
10
85728
0.463
39692.064
PV of Cash Inflows
332903.056
PV of Cash Outflows
410000
NPV
(77096.944)
Please leave a comment in case you have any further doubts.
Year
Cash Flows
PVF@8%
PV
1
46000
0.926
42596
2
58800
0.857
50391.6
3
53040
0.794
42113.76
4
48432
0.735
35597.52
5
44752
0.681
30476.112
6
41792
0.630
26328.96
7
40480
0.583
23599.84
8
40480
0.540
21859.2
9
40496
0.500
20248
10
85728
0.463
39692.064
PV of Cash Inflows
332903.056
PV of Cash Outflows
410000
NPV
(77096.944)
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