Smithy Inc. has developed a new car engine. It would cost $22 million at Year 0
ID: 2652231 • Letter: S
Question
Smithy Inc. has developed a new car engine. It would cost $22 million at Year 0 to buy the equipment necessary to manufacture the server. The project would require net working capital at the beginning of each year in an amount equal to 12% of the year?s projected sales; for example, NWC0 = 12%(Sales 1). The engine would sell for $10,000 per unit, and Smithy Inc. believes that variable costs would amount to $5,500 per unit. After Year 1, the sales price and variable costs will increase at the inflation rate of 4%. The company?s non-variable costs (fixed costs without depreciation) would be $2 million at Year I and would increase with inflation. The server project would have a life of 4 years. If the project is undertaken, t must be continued for the entire 4 years. Also, the project?s returns are expected to be highly correlated with returns on the firm?s other assets. The firm believes it could sell 1,500 units per year. The equipment would be depreciated over a 5-year period, using MACRS rates (given in the book in the solved example for chapter 11). The estimated market value of the equipment at the end of the project?s 4-year life is $2 million. Smithy Inc.?s federal-plus-state tax rate is 40%. Its cost of capital is 12% for average-risk projects, defined as projects with a coefficient of variation of NPV between 0.8 and 1.2. Low-risk projects are evaluated with a WACC of 10%, and high risk projects at 14%. 11. Calculate the net cash flows for Smithy?s new project. Based on its NPV should the project be taken?Explanation / Answer
It is a capital investmet project. It will mean long term project. Here you have to invest a lump sum money initially. Then it will generate cash inflows for next few years until its life expires.
Here company wants to maufacture a new engine. It requires initial investment in new equipment. Its purchase price is $22 million. Also you have to introduce 12% of next years sale as working capital. It is assumed that entire working capital invested will be recovered in last year. Project life is 4 years. In each year it will sale 1,500 units of engine. Sale price per engine in year 1 is $10,000. This rate will go up 4% in each year due to inflation.
Cost of the engine is partly variable and partly fixed in nature. Variable cost of year 1 is $5,500 per unit. It will increase again by 4% due to inflation in each year. Also fixed cost of first year is $2 million in year 1. It will increase by 4% again per year due to inflation.
Yiu have to charge MACRS 5 year depreciatio rate. After 4 year scrap value is $2 millio. You have to assume tax rate of 40%. Firm is required to estimate (1) cash flow (2) net preset value ad decisio o iverstmert.
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The problem has been solved in three stazes. In first staze some basic calculations are made. It is required for estimating cash flow and net present value. It is shown in the understated table.
Explanation :
1. First calculation is sale revenue. Quantity of each year is 1,500 engine. But sale price is changing. In first year it is $10,000. Then it is going up by 4%. Calculation is by compounding. The formula is $10,000 (1.04)n-1 Here 'n' is the number of year. So second year sale price is first year sale price multiplied by (1.04)1. Here 0.04 in the bracket has been used to indicate inlation rate. This price has been multiplied by the quantity sold to get total sales. It is shown in point 4 above.
2. Second most important point depreciation. It has been calculated at 5 years MACRS rate. It is the rate prescribed in percentage on equipment value under federal guideline. Rates are mentioned in point 8. Note that full amount has not been recovered in four year. This method will recover 100% cost of machine in six years. Thus at the end of 4th year there will be a book value. Here salvage value is higher than book value. So difference is capital gain. Tax is paid on it. After deducting tax from salvage value, balance cash flow will be received at the end of 4th year. It will be a part of the inflow of 4th year. Depreciationfigures are show i poit 8 above.
3. Working capital is another important area. Since firm has to introduce 12% of the sale value as working capital at the first date of the year, company will introduce it at the last date of pervious period. Thus 12% of sale value is working capital investmet at tme 0. In second year consider 12% of third year sale. See how much extra working capital is needed now. It will be invested at the end of the first year. In this manner first three year will require some fresh working capital introduction. In fourth year it will be recovered in full. So it will be cash inlow.
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In the second staze cash flow calculations are made for different years. It is shown in the table below:
Calculatios are made as follows:
1. First cosider sale value. It is cash iflow.
2. now deduct variable and fixed cost. Also deduct depreciation. Balance is net operating revenue before tax.
3. Deduct tax now to get net revenue after tax.
4. add depreciation to covert it into cash flow.
5. Finally add working capital recovered and deduct working capital introduced to get net cash flow. Also add after salvage value in the last year.
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In the last staze net present value has been estimated. It is shown below;
now you have take cash flow figures of previous table. Multiply them by discounting factor to convert them into present value. Here average risk WACC rate of 12% has been used in discount factor calculation. Yearly present values are added to get gross present value. From this figure deduct initial investmentof year 0 to get net present value.
Result: net present value is minus $7.08 million. So capital project should not be accepted.
Initial calculations for cash flow ad et preset value Year 0 Year 1 Year 2 Year 3 Year 4 Total 1 Cost of new equipment ( million) $22 2 Projected sale ( units per year) 1,500 1,500 1,500 1,500 6,000 3 Sale price per unit $ 10,000.00 $ 10,400.00 $ 10,816.00 $ 11,248.64 4 Sale value (million) $ 15.00 $ 15.60 $ 16.22 $ 16.87 $ 63.70 5 Working capital required ( million) $ 1.80 $ 1.87 $ 1.95 $ 2.02 6 Working capital to be introduced $ 1.80 $ 0.07 $ 0.07 $ 0.08 $ 2.02 7 Workig capital recovered ( million) $ 2.02 8 Depreciation MACRS rate 20% 32% 19.20% 11.52% 83% 9 Depreciation (1x8) ( million) $ 4.40 $ 7.04 $ 4.22 $ 2.53 $ 18.20 10 Variable cost per unit $5,500 $ 5,720.00 $ 5,948.80 $ 6,186.75 11 Total variable cost (2x10) (In million) $ 8.25 $ 8.58 $ 8.92 $ 9.28 $ 35.03Related Questions
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