Better Mousetraps has developed a new trap. It can go into production for an ini

Question

Better Mousetraps has developed a new trap. It can go into production for an initial investment in equipment of $6.3 million. The equipment will be depreciated straight line over 6 years to a value of zero, but in fact it can be sold after 6 years for $694,000. The firm believes that working capital at each date must be maintained at a level of 10% of next year’s forecast sales. The firm estimates production costs equal to $2.00 per trap and believes that the traps can be sold for $8 each. Sales forecasts are given in the following table. The project will come to an end in 6 years, when the trap becomes technologically obsolete. The firm’s tax bracket is 35%, and the required rate of return on the project is 10%. Use the MACRS depreciation schedule.

a. What is project NPV? (Negative amount should be indicated by a minus sign. Do not round intermediate calculations. Enter your answer in millions rounded to 4 decimal places.)

b. By how much would NPV increase if the firm depreciated its investment using the 5-year MACRS schedule? (Do not round intermediate calculations. Enter your answer in whole dollars not in millions.)

Explanation / Answer

Year 0 1 2 3 4 5 6 Sales Units 0.4 0.5 0.6 0.6 0.8 0.5 Revenue 0 3.2 4 4.8 4.8 6.4 4 Net working capital 0.32 0.4 0.48 0.48 0.64 0.4 Cash flow from net working capital -0.32 -0.08 -0.08 0 -0.16 0.24 0.4 a If straightline depreciation is used In Millions Year 0 1 2 3 4 5 6 Revenue 0 3.2 4 4.8 4.8 6.4 4 Less : Expenses -0.8 -1 -1.2 -1.2 -1.6 -1 Depreciation -1.05 -1.05 -1.05 -1.05 -1.05 -1.05 Pretax Profit 1.35 1.95 2.55 2.55 3.75 1.95 Tax 0.4725 0.6825 0.8925 0.8925 1.3125 0.6825 Net Income 0.8775 1.2675 1.6575 1.6575 2.4375 1.2675 Add: Depreciation 1.05 1.05 1.05 1.05 1.05 1.05 Free Cash flow 0 1.9275 2.3175 2.7075 2.7075 3.4875 2.3175 Cash flow from Investment -6.3 Cash flow from net working capital -0.32 -0.08 -0.08 0 -0.16 0.24 0.4 Cash Flow 0 1.9275 2.3175 2.7075 2.7075 3.4875 2.3175 Total cash flow -6.62 3.775 4.555 5.415 5.255 7.215 5.035 Discount factor @ 10% 1 0.909091 0.826446 0.751315 0.683013 0.620921 0.564474 PV of cash flow -6.6200 3.4318 3.7645 4.0684 3.5892 4.4799 2.8421 NPV 15.5560 Depreciation = 6.3/6 b) MACRS depreciation In Millions Year 0 1 2 3 4 5 6 Revenue 0 3.2 4 4.8 4.8 6.4 4 Less : Expenses -0.8 -1 -1.2 -1.2 -1.6 -1 Depreciation -1.26 -2.016 -1.2096 -0.72572 -0.72572 -0.36286 Pretax Profit 1.14 0.984 2.3904 2.874284 4.074284 2.637142 Tax 0.399 0.3444 0.83664 1.005999 1.425999 0.923 Net Income 0.741 0.6396 1.55376 1.868285 2.648285 1.714142 Add: Depreciation 1.26 2.016 1.2096 0.725716 0.725716 0.362858 Free Cash flow 0 2.001 2.6556 2.76336 2.594001 3.374001 2.077 Cash flow from Investment -6.3 Cash flow from net working capital -0.32 -0.08 -0.08 0 -0.16 0.24 0.4 Cash Flow 0 1.9275 2.3175 2.7075 2.7075 3.4875 2.3175 Total cash flow -6.62 3.8485 4.8931 5.47086 5.141501 7.101501 4.7945 Discount factor @ 10% 1 0.909091 0.826446 0.751315 0.683013 0.620921 0.564474 PV of cash flow -6.6200 3.4986 4.0439 4.1103 3.5117 4.4095 2.7064 NPV 15.6604 MACRS Rate Depreciation 0.2 6.3 1.26 0.32 6.3 2.016 0.192 6.3 1.2096 0.115192982 6.3 0.725716 0.115192982 6.3 0.725716 0.057596491 6.3 0.362858 Change in NPV NPV as per straightline 15.55596 NPV as per MACRS rate 15.660416 Change in NPV 0.1044565 104456.5

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