You are considering investing in a new product line that has the following Pro F
ID: 2654636 • Letter: Y
Question
You are considering investing in a new product line that has the following Pro Forma Income Statement over the next five years.
Sales (100,000 units at $5.00/unit)
$500,000
Variable Costs ($4.00/unit)
400,000
Gross profit
$ 100,000
Fixed costs
25,000
Depreciation ($200,000 / 5)
40,000
EBIT
$ 35,000
Taxes (30%)
10,500
Net Income
$ 24,500
To start this project, you must invest $200,000 in the new equipment, which will be depreciated using the straightline method to a book value of 0 at the end of the five years. Additionally, you must invest $45,000 in new Working Capital at time-zero to fund the new inventory and accounts receivable. This investment in Working Capital is assumed to be recovered in full at project termination in five years from now. Finally, at project termination, you assume that you can sell the equipment for $10,000 (salvage value) in five years. The firm’s income tax rate is 30%. If the required rate of return is 15%, should you take the project? Also, what is the project’s IRR?
Sales (100,000 units at $5.00/unit)
$500,000
Variable Costs ($4.00/unit)
400,000
Gross profit
$ 100,000
Fixed costs
25,000
Depreciation ($200,000 / 5)
40,000
EBIT
$ 35,000
Taxes (30%)
10,500
Net Income
$ 24,500
Explanation / Answer
Terminal value = Post Tax salvage Value + Working capital realised back
Terminal value = 10000*(1-30%) + 45000
Terminal value = 52000
Annual Cash Flow = Net Income + Depreciation
Annual Cash Flow = 24500 + 40000
Annual Cash Flow = 64500
Initial Investment = 200000 + 45000
Initial Investment = 245000
NPV = -245000 + 64500*PVA(15%,5) + 52000*PV(15%,5)
NPV = -245000 + 64500*3.352155 + 52000*0.497177
NPV = -2932.81
Decision : No, The project should not be taken as its NPV is negative
Using Excel Formula
Project’s IRR = irr(values)
Project’s IRR = irr({-245000,64500,64500,64500,64500,116500})
Project’s IRR = 14.53%
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