Desai Industries is analyzing an average-risk project, and the following data ha

Question

Desai Industries is analyzing an average-risk project, and the following data have been developed. Unit sales will be constant, but the sales price should increase with inflation. Fixed costs will also be constant, but variable costs should rise with inflation. The project should last for 3 years, it will be depreciated on a straight-line basis, and there will be no salvage value. No change in net operating working capital would be required. This is just one of many projects for the firm, so any losses on this project can be used to offset gains on other firm projects. What is the project's expected NPV?

10.0%

$200,000

48,000

$25.00

$150,000

$20.20

33.333%

5.00%

40.0%

WACC

10.0%

Net investment cost (depreciable basis)

$200,000

Units sold

48,000

Average price per unit, Year 1

$25.00

Fixed op. cost excl. depr. (constant)

$150,000

Variable op. cost/unit, Year 1

$20.20

Annual depreciation rate

33.333%

Expected inflation rate per year

5.00%

Tax rate

40.0%

Explanation / Answer

Computation of real cost of capital which to be used as discounting factor. Real rate of Cost of Capital = (1+ Nominal Cost of Capital / 1 + Inflation Rate) - 1 = (1.10/1.05) -1 = 4.76%

Computation of Earning After Tax Amount($) i Sales ($) 48,000 x 25 1,200,000 ii Variable Cost 48000 x 20.20            (969,600) iii Contribution 230,400 iv Fixed Costs: v Depreciation 200000/3      (66,666.67) vi Fixed Opearting cost    (150,000.00) vii Total Fixed Cost      (216,666.67) viii EBT          13,733.33 ix Tax at 40%          (5,493.33) x EAT             8,240.00

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