You are evaluating a project for The Tiff-any golf club, guaranteed to correct t

Question

You are evaluating a project for The Tiff-any golf club, guaranteed to correct that nasty slice. You estimate the sales price of The Tiff-any to be $400 per unit and sales volume to be 1,000 units in year 1; 1,500 units in year 2; and 1,325 units in year 3. The project has a 3-year life. Variable costs amount to $225 per unit and fixed costs are $100,000 per year. The project requires an initial investment of $165,000 in assets, which will be depreciated straight-line to zero over the 3-year project life. The actual market value of these assets at the end of year 3 is expected to be $35,000. NWC requirements at the beginning of each year will be approximately 20 percent of the projected sales during the coming year. The tax rate is 34 percent and the required return on the project is 10 percent.

What is the operating cash flow for the project in year 2?

Explanation / Answer

Operating Cash flows before depreciation (post tax) per year:

Year 1 = [1000 units x (400 - 225) - 100000] x (1-0.34) = $49500

Year 2 = [1500 units x (400 - 225) - 100000] x (1-0.34) = $107250

Year 3 = [1325 units x (400 - 225) - 100000] x (1-0.34) = $87038

Tax Saving on depreciation per year = (165000 / 3) x 0.34 = $18700

Cash inflows per year :

Year 1 = 49500 + 18700 = $68200

Year 2 = 107250 + 18700 = $125950

Year 3 = 87038 + 18700 = $105738

Present Value of Operating Cash Inflows per year:

Year 1 = 68200 x 0.909 = $61994

Year 2 = 125950 x 0.826 = $104035

Year 3 = 105738 x 0.751 = $79409

Present Value of Cash ouflows:

Year 0 = 165000 + (400000x20%) = $245000

Year 1 = [600000x 20%] x 0.909 = $109080

Year 2 = [530000x 20%] x 0.826 = $87556

Reversal of NWC:

Year 3 = [400000x20%] + [600000x20%] + [530000x20%] = $306000

Present Value of Reversal of NWC = 306000 x 0.751 = $229806

Scrap Value Net of Tax (Present Value)

Year 3 = 35000 (1-0.34) = $23100

Present Value of Cash inflows = 61994 + 104035 + 79409 + 229806 + 23100

= $498344

Present Value of Cash outflows = 245000 + 109080 + 87556

= $441636

NPV = Present Value of Cash inflows - Present Value of Cash outflows

= 498344 - 441636

= $56708

The project is feasible as the NOV is positive.

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