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 $6.0 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 $530,000. The firm believes that working capital at each date must be maintained at a level of 15% of next year’s forecast sales. The firm estimates production costs equal to $1.90 per trap and believes that the traps can be sold for $6 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 9%. Use the MACRS depreciation schedule.

Year: 0 1 2 3 4 5 6 Thereafter Sales (millions of traps)

0 .4 .5 .6 .6 .8 .4 0

Suppose the firm can cut its requirements for working capital in half by using better inventory control systems. By how much will this increase project NPV? (Enter your answer in millions rounded to 4 decimal places.) NPV $ million

Explanation / Answer

Net Present Value is the sum of discounted cash flows = $1646316.02 = $1.64631602 million

Formulas:

Depreciation = 6000000/6 = $1000000

Initail Investment = 6000000 + 360000 = $6360000

For Years 1 to 5

Cash Flow = (Sales - Production Cost - Depreciation) * (1 - Tax Rate) + Depreciation - Working Capital

For Year 6

After Tax Slavage Value = Salvage Value - (Salvage Value - Book Value) * Tax Rate

                                          = 530000 - (530000 - 0) * 0.35 = 530000 - 185500 = $344500

Cash Flow = (Sales - Production Cost - Depreciation) * (1 - Tax Rate) + Depreciation - Working Capital + After Tax Salvage Value

Suppose the firm can cut its requirements for working capital in half by using better inventory control systems. The cash flows would be as follows:

The NPV will become $1955044.92 = $1.95504492 million

Increase in NPV = 1955044.92 - 1646316.02 = $308728.90 = $0.3087 million

Year Initial Investment Working Capital Sales(millions of traps) Sales Production Cost Depreciation Salvage Value After Tax Salvage Value Cash Flow Discounted Cash Flow 0 6000000 360000 0 0 0 0 0 0 -6360000 -6360000.00 1 0 450000 400000 2400000 760000 1000000 0 0 966000 886238.53 2 0 540000 500000 3000000 950000 1000000 0 0 1142500 961619.39 3 0 540000 600000 3600000 1140000 1000000 0 0 1409000 1088006.52 4 0 720000 600000 3600000 1140000 1000000 0 0 1229000 870654.58 5 0 360000 800000 4800000 1520000 1000000 0 0 2122000 1379154.40 6 0 -2970000 400000 2400000 760000 1000000 530000 344500 4730500 2820642.59 NET PRESENT VALUE 1646316.02

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