You are evaluating a project for a small manufacturing firm. The firm has provid

Question

You are evaluating a project for a small manufacturing firm. The firm has provided the following information: the initial cost of the project is $2,500 for equipment purchase; the CCA rate is 10 percent; tax rate is 25 percent; and the pre-tax cash flow in the first year is $900. Cash flows are expected to increase at 5 percent a year for four years. At the end of the fourth year, the project will end and the machinery acquired to start the project will be scrapped (zero salvage value). The appropriate discount rate is 7 percent.
(1)   Should the firm accept the project?
(2)   You have also obtained the following information about the best- and worst-case scenarios. In the best case, the cash flow in the first year will be $1100 and will grow at 6 percent a year. In the worst case, the cash flow in the first year will be $600 and will grow at 2 percent a year. The base case was presented above and everything else is the same for the base-, best-, worst-case scenarios. Calculate the NPV of the best case and the NPV of the worst case. Based on the NPVs of the base, best, and worst cases, what

Explanation / Answer

(1) Computaion of Net Present value as per the information given in question(Base case).We get,

Net present value = Present value of Free cash flow - Initial investment

Net Present value = 2,636.94 - 2,500 = $ 136.94.

Hence, Net present value is positive i.e $ 136.94.So, it is acceptable.

(2)Computaion of Net Present value as per the information given in question(best case).We get,

Note: Cash flow is increasing at the rate of 6% per year.

Net Present value = 3,265.80 - 2500.00 = $ 765.80

Computaion of Net Present value as per the information given in question(Worst Case).We get,

Note: Cash flow is increasing at the rate of 2% per year.

Net Present Value = 1,751.48 - 2500.00 = - 748.52

Conclusion; based on the NPV, base and best situaation is best of accepting the project.Because, it gives positive cash flow. But, Worst situation is not good for the project because it gives negative cash flow during the period.

Years 1 2 3 4 Total Value Cash Flow($) 900.00 945.00 992.25 1,041.86 3,879.11 Less: CCA 250.00 225.00 202.50 182.25 (859.75) Cash Flow before tax($) 650.00 720.00 789.75 859.61 3,019.36 Less: Tax ($) 162.50 180.00 197.44 214.90 (754.84) Cash Flow after Tax($) 487.50 540.00 592.31 644.71 2,264.52 Add; Depreciation($) 250.00 225.00 202.50 182.25 859.75 Free Cash Flow ($) 737.50 765.00 794.81 826.96 3,124.27 Present value factor @7% 0.935 0.873 0.816 0.763 Present value of Free cash flow($) 689.56 667.85 648.56 630.97 2,636.94

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