Summer Tyme, Inc. is considering a new three-year expansion project that require

Question

Summer Tyme, Inc. is considering a new three-year expansion project that requires an initial fixed asset investment of $3.9 million, after which time it will be worthless. The project is estimated to generate $2,650,000 annual sales, with costs of $840,000. The tax rate is 35%.The required return is 12%. Suppose the project requires an initial investment in net working capital of $300,000 and the fixed asset will have a market value of $210,000 at the end of the project.

Show how to find the new NPV using Microsoft Excel functions NPV and/or IRR

Explanation / Answer

The problem is related with capital budgeting. Company wants to invest in 3 years expansion plan. Initial investment in the asset is $3.9 millio. After 3 years it will be useless but can realize $210,000 from sale. Also $300,000 working capitaL is required. As nothing has been mentioned, it is assumed that full money will be recovered.

1. Each year annual sales is $2,650,000. Deduct cost of $840,000 to get net profit before depreciation and tax.

2. Next assume that equal amount of depreciation i.e. 3.9 million/3 years=$1.3 million is charged in each year. Deduct it from net figure of point 1 to get net profit before tax.

3. From the figure of 2, deduct 35% tax. You will get net profit after tax. Add back depreciation with it to get cash inflow from trading activities in each of the three years.

4. In third year, in addition to cash flow from trading activity, there will be salvage value and working capital returned

So cash flow of three years are as follows:

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After ascertaining annual cash flow you have to ascertain net present value (NPV). It is calculated in the following manner-

1. Take present value of cash flow of each of these three years. It is ascertained by using discounting rate of 12%.

2. Then sum the present value of cash inflows of three years. It is gross present value (GPV)

3. From GPV deduct inittial investment to get NPV.

Calculations are shown below:

Result: Here NPV is positive. It implies that return is more than 12%. So it will addvalue in the concern. So this project is recommendable.

Statement showing cash flow from capital project Details Year 1 Year 2 Year 3 Total 1. Annual sales 2,650,000 2,650,000 2,650,000 7,950,000 2. Annual cost 840,000 840,000 840,000 2,520,000 3. Net profit before depreciation [1-2] 1,810,000 1,810,000 1,810,000 5,430,000 4. Depreciation 1300000 1300000 1300000 3,900,000 5. Net profit before tax [3-4] 510,000 510,000 510,000 1,530,000 6. Tax 35% of (5) 178500 178500 178500 535,500 7. Net profit after tax [5-6] 331,500 331,500 331,500 994,500 8. Add back depreciation [4] 1300000 1300000 1300000 3,900,000 9. Cash flow from trading activities [7+8] 1,631,500 1,631,500 1,631,500 4,894,500 10. Cash flow from sale of assets 210,000 210,000 11. Working capital recovered 300,000 300,000 12. Total cash flow [9+10+11] 1,631,500 1,631,500 2,141,500 5,404,500

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