A firm is considering an expansion project that will last forever. The project r

Question

A firm is considering an expansion project that will last forever. The project requires an immediate purchase of a new piece of equipment that costs $600, 000. The equipment will be fully depreciated using straight-line method over the next four years. The project will generate annual sales of $800, 000 and incur additional annual costs of $200, 000 (all costs except depreciation) for each year. Due to this project, the firm has to immediate increase the inventory by $100, 000 and the accounts payable by $50.000. The corporate tax rate is 30%. Calculate the project cash flow for each year (0, 1, 2, 3, and 4). .Assume that the cash flow will increase by 2% forever beyond year 4. Evaluate the project using Payback period, Discounted payback period, and NPV .Assume that the discount rate for the project is 15%.

Explanation / Answer

1. Project Cash flows:

Payback period:

Payback = 1 year + [(600000-465000) / (930000-465000)]

= 1.29 years

Discounted payback = 1 year + [(600000-404550) / (756090-404550)]

= 1.56 years

PV of cash inflows = 1356640 + [(420000x1.02)/1.155] / [1-1.02/1.15]

= 1356640 + 1884147

= $3240787

PV of cash ouflows = $650000

NPV = 3240787 - 650000

= $2590787

Year 0 1 2 3 4 Investment -600000 Tax savings on dep. 45000 45000 45000 45000 Cash inflows ex dep. after tax 420000 420000 420000 420000 Investment in NWC -50000 Reversal of NWC 50000 Cash flows -650000 465000 465000 465000 515000

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