Dow Chemical is considering a project that is expected to last 4 years with the

Question

Dow Chemical is considering a project that is expected to last 4 years with the following details: Year 1 revenues of $560,000 increasing at 5% per year thereafter. Costs for year 1 are $200,000 and are expected to increase at 6% per year thereafter. The project will require new equipment valued at $400,000. This equipment will be depreciated to zero using the straight-line depreciation method over the 4-year life. Working capital at the firm will have to rise to $50,000 from the current level of $10,000 immediately, will fall down to $30,000 in year 2 and back to the original $10,000 level in year 4. The firm’s average tax rate is 24% and its marginal tax rate is 38%. Forecast all incremental CFs for this project and compute its NPV based on a discount rate of 12%.

Explanation / Answer

Calculation of incremental cash flows of the project Year 0 1 2 3 4 Investment in equipment -$400,000.00 Change net working capital -$40,000.00 $20,000.00 $20,000.00 Operating cash flow $261,200.00 $271,120.00 $281,461.60 $292,241.42 Incremental Cash flows of the project -$440,000.00 $261,200.00 $291,120.00 $281,461.60 $312,241.42 Calculation of NPV of project Year Cash flow Discount factor @ 12% Present Values 0 -$440,000.00 1 -$440,000.00 1 $261,200.00 0.89285714 $233,214.29 2 $291,120.00 0.79719388 $232,079.08 3 $281,461.60 0.71178025 $200,338.81 4 $312,241.42 0.63551808 $198,435.06 NPV of the project $424,067.24 Working Depreciation per year = Cost of an equipment / useful life of an asset = $400000 / 4 years = $1,00,000 Computation of operating cash flows of the project Year 1 2 3 4 Revenue $560,000.00 $588,000.00 $617,400.00 $648,270.00 less : Costs $200,000.00 $212,000.00 $224,720.00 $238,203.20 less : Depreciation $100,000.00 $100,000.00 $100,000.00 $100,000.00 Profit before tax $260,000.00 $276,000.00 $292,680.00 $310,066.80 Less : Tax @ 38% $98,800.00 $104,880.00 $111,218.40 $117,825.38 Add : Depreciation $100,000.00 $100,000.00 $100,000.00 $100,000.00 Incremental Cash flow from Project $261,200.00 $271,120.00 $281,461.60 $292,241.42

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