You have been asked by the president of your firm to evaluate the proposed acqui
ID: 2727818 • Letter: Y
Question
You have been asked by the president of your firm to evaluate the proposed acquisition of new special-purpose equipment. The equipment's base price is $500,000, and another $50,000 for its installation costs. The equipment falls into the MACRS 3-year class, and it will be sold at the end of the project’s 2-year life for $250,000. Use of the equipment will require net working capital investment equivalent to 20% of the following year’s incremental revenues. The equipment will increase annual revenues by $100,000, and save the firm $200,000 in annual operating costs. The annual revenues and operating costs are expected to grow at an annual rate of 10% during the 2nd-year of the project. This equipment will be placed in an unoccupied site, which can otherwise be sold for $100,000 today. This site will be sold for the same price at the termination of the project. The depreciation of this site that your firm owns can be ignored. The firm's tax rate is 30 percent and the discount rate for the project is 12%.
(a) Compute the non-operating cash flows (i.e., capital spending and change in NWC) at the end of Year 2. <$333,679>
(b) What is the NPV <$73,430>
The answers are listed next to the questions. I'm looking for a breakdown of how to arrive at those answers.
Thank you.
Explanation / Answer
(a)
Net working capital = 20% of following year’s incremental revenue
Incremental revenue for year 1 = $100,000
Incremental revenue for year 2 = $100,000 * 110% = $110,000
NWC released at the end of year 2 = NWC introduced at the end of year 1 = $110,000 * 20% = $22,000
Cost of Equipment = Base price + Installation costs = $500,000 + $50,000 = $550,000
Depreciation for year 1 = $550,000 *33.33% = $183,315
Depreciation for year 2 = $550,000 * 44.45% = $244,475
Book value of equipment at the end of year 2 = Cost of equipment - Depreciation for year 1 and year 2 = $550,000 - $183,315 - $244,475 = $122,210
Sale value of equipment = $250,000
Gain on sale of equipment = Sale value – book value = $250,000 - $122,210 = $127,790
Tax on gain on sale of equipment = $127,790 * 30% = $38,337
Net cash inflow on sale of equipment = Sale value – Tax on gain on sale = $250,000 - $38,337 = $211,663
Total Non-operating cash flows at the end of year 2 = Sale of equipment + Release of Net working capital + Sale of site = $211,663 + $22,000 + $100,000 = $333,663
(b)
Year
0
1
2
Incremental revenue
$ 100,000.00
$ 110,000.00
Savings in operating costs
$ 200,000.00
$ 220,000.00
Depreciation
$ 183,315.00
$ 244,475.00
Net income before tax
$ 116,685.00
$ 85,525.00
Tax @30%
$ 35,005.50
$ 25,657.50
Net income
$ 81,679.50
$ 59,867.50
Add: Depreciation
$ 183,315.00
$ 244,475.00
Operating cashflows
$ 264,994.50
$ 304,342.50
Cost of equipment
-$ 550,000.00
Net working capital
-$ 20,000.00
-$ 2,000.00
$ 22,000.00
Sale of equipment
$ 211,663.00
Opportunity cost of unoccupied site
-$ 100,000.00
Sale of site
$ 100,000.00
Non Operating cash flows
-$ 670,000.00
-$ 2,000.00
$ 333,663.00
Free cashflows
-$ 670,000.00
$ 262,994.50
$ 638,005.50
Present value factor at 12%
1
0.8929
0.7972
Present value of free cash flows
-$ 670,000.00
$ 234,827.79
$ 508,617.98
Net present value = -$670,000 + $234,827.29 + $508,617.98 = $73,445.77
Year
0
1
2
Incremental revenue
$ 100,000.00
$ 110,000.00
Savings in operating costs
$ 200,000.00
$ 220,000.00
Depreciation
$ 183,315.00
$ 244,475.00
Net income before tax
$ 116,685.00
$ 85,525.00
Tax @30%
$ 35,005.50
$ 25,657.50
Net income
$ 81,679.50
$ 59,867.50
Add: Depreciation
$ 183,315.00
$ 244,475.00
Operating cashflows
$ 264,994.50
$ 304,342.50
Cost of equipment
-$ 550,000.00
Net working capital
-$ 20,000.00
-$ 2,000.00
$ 22,000.00
Sale of equipment
$ 211,663.00
Opportunity cost of unoccupied site
-$ 100,000.00
Sale of site
$ 100,000.00
Non Operating cash flows
-$ 670,000.00
-$ 2,000.00
$ 333,663.00
Free cashflows
-$ 670,000.00
$ 262,994.50
$ 638,005.50
Present value factor at 12%
1
0.8929
0.7972
Present value of free cash flows
-$ 670,000.00
$ 234,827.79
$ 508,617.98
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