Tring to understand how to find the first component of the problem which involve

Question

Tring to understand how to find the first component of the problem which involves using the Project Parameters and Scenario values to find the NPV and IRR for scenarios 1,2, and 3.

Project Parameters:

Suppose, we can sell 50,000 cans of shark attractant per year at a price of $4.00 per can. It costs us about $2.50 per can to make the attractant. A new product such as this one typically has only a three-year life. We require a 20% return on new products.

Fixed costs for the project will run $12,000 per year.

We will need to invest a total of $90,000 in manufacturing equipment. For simplicity, we will assume that this $90,000 will be fully depreciated over the three year life of the project.

The project will require an initial $20,000 investment in net working capital.

The tax rate is 34%.

Scenario:

Number of cans 50000 Price per can 4 Cost per can 2.5 Fixed Cost 12000 Tax rate 34% Discount rate 20% Initial Investment 90000 0 1 2 3 Revenue $ 200,000 COGS $   125,000 Gross Profit $     75,000 Fixed Cost $     12,000 EBITDA $    63,000 Depreciation EBIT Tax Net Income NCS $ (90,000) NWC $ (20,000) $ 20,000 CFFA NPV Hint: It should be $10,648 for the Base Case. IRR

Explanation / Answer

Solution: Income Statement of Shark Attractant Sales (50,000 units at $4.00/unit) $ 200,000 Variable Costs ($2.50/ unit) $   125,000 Gross Profit (Sales - Variable cost) $     75,000 Fixed Cost $     12,000 Depreciation ($90,000/3) $        30,000 EBIT = Gross Profit - Fixed Cost - Depreciation $        33,000 Taxes (34%) = $33,000*34% $        11,220 Net Income = EBIT - Taxes (34%) $        21,780 Add back depreciation to get Operating Cash-flow (OCF). Formulae: Operating Cash Flow (OCF) = EBIT + depreciation – taxes OCF = Net income + depreciation when there is no interest expense Cash Flow From Assets (CFFA) = OCF – net capital spending (NCS)– changes in NWC OCF = Net income + depreciation when there is no interest expense Cash Flow From Assets (CFFA) = OCF – net capital spending (NCS) – changes in NWC Project cash flow = Project OCF – Project net capital spending – project change in net working capital Projected Total Cash Flows of Shark Attractant Year 0 1 2 3 OCF $51,780 $51,780 $51,780 Change in NWC $20,000 Capital Spending (NCS) ($20,000) CFFA ($90,000) Total ($110,000) $51,780 $51,780 $71,780 Making The Decision Enter the cash flows into the calculator and compute NPV and IRR CF0 = -110,000; C01 = 51,780; F01 = 2; C02 = 71,780 NPV; I = 20; CPT NPV = 10,648 CPT IRR = 25.8% Should we accept or reject the project? More on NWC Why do we have to consider changes in NWC separately? 1) GAAP requires that sales be recorded on the income statement when made, not when cash is received 2) GAAP also requires that we record cost of goods sold when the corresponding sales are made, regardless of whether we have actually paid our suppliers yet 3) Finally, we have to buy inventory to support sales although we haven’t collected cash yet NWC = (Cash + AR + Inventory) - (AP + NP)

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