You have been hired as a financial consultant for Crazy Inc. Apps (CIA), a publi

Question

You have been hired as a financial consultant for Crazy Inc. Apps (CIA), a publicly traded firm that is the leader in Apps for smartphones. The company is looking at setting up a new computer lab to produce the next generation of Apps. This will be a five-year project. The company bought some land three years ago; the value of the land today is $7.1 M. In five years, the after-tax value of the land will be $7.4 M. The company wants to build its new lab in this land. The cost of the building and equipment of the lab will be $40M. Here is some more info on CIA: CIA has decided to raise the funds needed to build the lab by issuing new shared of common stock, without any intermediary or underwriter. CIA's tax rate is 35%. The project requires $1,400,000 in initial net working capital investment to get operational. Calculate the project's initial Time 0 cash flow, taking into account all side effects. The new lab is somewhat riskier than a typical project for CIA, because it is a new untested idea. You should increase the discount rate of this project by 2% to account for the added risk. Calculate the appropriate discount rate to use when evaluating the project. The manufacturing plant has an eight-year tax life, and CIA uses straight-line depreciation. At the end of the project (that is, the end of Year 5), the building and equipment can be scrapped for $8.5M. What is the after-tax salvage value of this plant and equipment? The company will incur $7,9M in annual fixed costs. The plan is to sell 20 M Apps per year and sell them for $1 each. The variable production costs for each App are zero. What is the annual operating cash flow (OCF) from this project? CIA's comptroller is primarily interested in the impact of CIA's investments on the bottom line of reported accounting statements. What is the accounting break-even quantity of Apps sold for this project? Finally, CIA's president is a humble man with humble tastes. All he wants to know is the Apps project's IRR and NPV.

Explanation / Answer

a) Project's initial time = 0 Cash Flow: Cost of building and equipment 40000000 Increase in NWC 1400000 Value of land (opportunity cost) 7100000 48500000 b) Since the project is going to be funded by common stock, the discount rate should be cost of equity. Cost of Equity as per CAPM = 3.6 + 1.25*7 = 12.35% Since 2% is to be added as premium for risk, the discount rate to be used is 14.35% c) Depreciation on building an equipment is 40,000,000/8 = 5000000 every year Book value at the end of the 5th year = 40000000-25000000 =15000000 Salvage value = 8500000 Loss on sale = 15000000-8500000 =7500000 Tax shield on loss = 7500000*0.35 = 2625000 After tax salvage value = 8500000+2625000 = $11,125,000 d) Annual Operating Cash Flow: Contribution-20m*(1-0) 20000000 fixed costs -7900000 depreciation -5000000 profit before tax 7100000 tax @ 35% -2485000 profit after tax 4615000 add depreciation 5000000 operting cash flow 9615000 Accounting break even quantity = 12900000/1 = 12.9 million apps. e) IRR & NPV: PV of annual operating cash flows = 9615000*pvifa(14.35,5) 9615000*3.4044 = 32733306 PV of terminal cash flow = (11125000+7400000+1400000)*pvif(14.35,5) 19925000*0.5115 = 10191638 PV of cash inflows 42924944 Initial investment 48500000 NPV(is negative) -5575057 Interest Interest IRR: factor @ 11% pv @ 11% factor @ 10% pv @ 10% annual operating cash flows 9615000 3.6959 35536079 3.7908 36448542 Terminal cash flow 19925000 0.5935 11825488 0.6209 12371433 47361566 48819975 IRR = 10 + 319975/1458405 = 10.22%

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