FITCO Inc. is a Pharmaceutical company which is considering investing in a new e

Question

FITCO Inc. is a Pharmaceutical company which is considering investing in a new equipment for the production of pain-reliever machine for individuals who suffer from cardio vascular diseases. The new equipment will cost $2,000,000, and an additional $100,000 is needed for installation. The equipment which falls into the MACRS 5-yr class, would be sold after 5 years for $150,000. The equipment will generate additional annual revenues of $965,000, and will have annual operating expenses of $300,000. An inventory investment of $60,000 is required during the life of the project. FITCO is in the 30 percent tax bracket, and has the same risk as the firm's existing assets. Its existing cost of capital is 15 percent.

1. Calculate the initial outlay of the project

2. Calculate the annual after-tax operating cash flows for year 1 to 5

3. Determine the terminal year non-operating cash flow in year 5

4. What is the project NPV?

5. What is the estimated IRR of the project (up to 2 decimal places)

6. Should the project be accepted based on the IRR criterion?

Show all workings.

Explanation / Answer

PV of cash flow = cashflow/(1+i)^n

i = 15% n = number of period

NPV= {Period Cash Flow / (1+R)^T} - Initial Investment

where R is the interest rate and T is the number of time periods. IRR is calculated using the NPV formula by solving for R if the NPV equals zero.

The formula for IRR is:

0 = P0 + P1/(1+IRR) + P2/(1+IRR)2 + P3/(1+IRR)3 + . . . +Pn/(1+IRR)n

where P0, P1, . . . Pn equals the cash flows in periods 1, 2, . . . n, respectively; and
IRR equals the project's internal rate of return.

Year 0 1 2 3 4 5 Cost of equipment          2,000,000 Installation              100,000 Investmnet in inventory                60,000 Intial outlay          2,160,000 Value of machine          2,100,000 Revenues           965,000    965,000    965,000    965,000    965,000 Operating expenses           300,000    300,000    300,000    300,000    300,000 Depreciation           420,000    672,000    403,200    241,920    241,920 Operating income           245,000      (7,000)    261,800    423,080    423,080 Depreciation rate 20.00% 32.00% 19.20% 11.52% 11.52% TAX @ 30%             73,500      78,540    126,924    126,924 After tax cash flow           171,500      (7,000)    183,260    296,156    296,156 Tax benefit on depreciation           126,000    201,600    120,960      72,576      72,576 Salvage value    150,000 Non operating cash flow Cash flows        (2,160,000)           297,500    194,600    304,220    368,732    518,732 PV @ 15%        (2,160,000)           258,696    147,146    200,030    210,824    257,901 NPV        (1,085,404) IRR -19.11%

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