Suppose a company has hired you to estimate the cash flows arising from a propos

Question

Suppose a company has hired you to estimate the cash flows arising from a proposed capital project by replacing old equipment with a $0 market value and a book value of $6000, and you have been handed the relevant data below. The project being considered has a 5-year tax life, and at the end of year 5 the asset will be worthless (i.e. salvage value =0). The CFO suggests that you depreciate the asset by using the straight-line method over the 5 year life of the project. Revenues and other operating costs are as noted below, and will be constant over the period.

Equipment cost: $150,000;   Book value of old equipment: $6000

Delivery and installation cost of equipment and remove old equipment: $50,000;

Straight-line depreciation rate: 20% (5-year);       Sales revenue each year: $100,000

Operating costs (excluding depreciation): $30,000;   Tax rate: 40%

10a. What are annual cash flows for the next five years? Hint: find CF0 to CF5

10b. Suppose CFO will borrow 50% of capital from a bank with 10% interest, and 50% of capital through equity with 22% of require rate of return. What is the cost of capital for this project?

10c. What is the net present value of this project and should you convince the CFO to accept or reject the new equipment?

10d. If the firm

Explanation / Answer

a)

b) cost of capital for this project = 50%*10%(1-40%) + 50%*22%= 14%

c)net present value of this project = -197600 + 58000*(1-1/1.14^5)/14%=$1,518.70

you should convince the CFO to accept the new equipment because NPV is positive

d) for IRR, NPV=0

-197600 + 58000*(1-1/(1+IRR)^5)/IRR =0

IRR = 14.32%

IRR>cost of capital

Therefore project should be accepted

0 1 2 3 4 5 Initial cost -200000 Revenue 100000 100000 100000 100000 100000 Operating costs -30000 -30000 -30000 -30000 -30000 Depreciation -40000 -40000 -40000 -40000 -40000 Cash flow from sale of old equipmnt 2400 Net incmoe 18000 18000 18000 18000 18000 Cash Flow -197600 58000 58000 58000 58000 58000

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