Project Description: After extensive research and development, Your company has
ID: 2763165 • Letter: P
Question
Project Description:
After extensive research and development, Your company has recently developed a new Widget and must decide whether to make the investment necessary to produce and marketing it. The widget is superior to current widgets in the marketplace. Research and Development costs have been $20 million so far. The product would be put on the market at the beginning of this year. We anticipate that test marketing the project will cost $1 million dollars. The plant will be in a building that we bought for $2 million dollars 30 years ago but a competitor who would like to buy our business offered us $3.5 million for the property a year ago. The property has a current book value of 5 million dollars due to renovation we did 5 years ago. We tried to sell the building this year for 4.5 million, but received no offers.
As a Financial Analyst you have been called in to do the evaluation of the project and to provide a recommendation. The Company must invest $150 million in new money for equipment. The equipment can be sold for $55 million at the end of five years. The appropriate deprecation schedule for the new equipment is the seven year MACRS depreciation schedule. The immediate initial working capital requirement is 15 million dollars. Thereafter the net working capital will be 15 percent of sales. General Administrative expenses are expected to be $25 million a year the first year and expected to increase with inflation each year. Annual expected inflation is expected to be 3.25 percent.
The widgets are expected to sell at 40 dollars while the cost to produce each widget is 20 dollars. The market for widgets is currently 30 million and is expected to increase by 1 percent each year. Our estimated share will be 10 percent and increase by 12 a percent each year of the project. We expect to be able to pass any effects of inflation to our customers since the market is not overly competitive. The company’s tax rate is 35 percent. The project is expected to end in 5 years.
You are to use three discount rates 5.13%, 5.41%, 5.59% to evaluate the project. Calculate the NPV, the IRR and the PI on the project. Discuss your capital budgeting decision on the widget project.
Explanation / Answer
Depreciation Schedule:
Year
Basis
%
Depreciation Expense
Accumulated
Depreciation
Ending
Book Value
1
$150,000,000
14.29%
$21,428,571
$21,428,571
$128,571,429
2
$150,000,000
24.49%
$36,734,694
$58,163,265
$91,836,735
3
$150,000,000
17.49%
$26,239,067
$84,402,332
$65,597,668
4
$150,000,000
12.50%
$18,742,191
$103,144,523
$46,855,477
5
$150,000,000
8.93%
$13,387,279
$116,531,802
$33,468,198
Year
1
2
3
4
5
Sales
$120,000,000.00
$120,600,000.00
$121,203,000.00
$121,809,015.00
$122,418,060.08
Less: COGS
$60,000,000.00
$60,300,000.00
$60,601,500.00
$60,904,507.50
$61,209,030.04
Less: General Administrative Exp.
$25,000,000.00
$25,812,500.00
$26,651,406.25
$27,517,576.95
$28,411,898.20
Less: Depreciation
$21,428,571.00
$36,734,694.00
$26,239,067.00
$18,742,191.00
$13,387,279.00
EBT
$13,571,429.00
-$2,247,194.00
$7,711,026.75
$14,644,739.55
$19,409,852.83
Less: tax @ 35%
$4,750,000.15
-$786,517.90
$2,698,859.36
$5,125,658.84
$6,793,448.49
Net Income
$8,821,428.85
-$1,460,676.10
$5,012,167.39
$9,519,080.71
$12,616,404.34
Add: Change in Net Working Capital
-$18,000,000.00
-$18,090,000.00
-$18,180,450.00
-$18,271,352.25
-$18,362,709.01
Add: Depreciation
$21,428,571.00
$36,734,694.00
$26,239,067.00
$18,742,191.00
$13,387,279.00
Add: Recovery of Working Capital
$0.00
$0.00
$0.00
$0.00
$105,904,511.26
Add: After tax salvage Value of machine
$0.00
$0.00
$0.00
$0.00
$47,463,869.30
OCF
$12,249,999.85
$17,184,017.90
$13,070,784.39
$9,989,919.46
$161,009,354.89
Calculations:
Year 1 Sales = 10% of 30 million Units x $40 = $120,000,000.00
In subsequent years, it will increase by 0.5%
Year 1 COGS = 10% of 30 million Units x $20 = $60,000,000.00
In subsequent years, it will increase by 0.5%
Year 1 General Admin Exp = $25,000,000
In subsequent years, it will increase by 3.25% every year.
Change in Net working capital = 15% of sales every year.
Recovery of working capital (all working capitals from year 0 to year 5) will occur at the end of 5th year.
After tax salvage value of machine = Market Value – ((Market value – book value)*tax rate)
= $55,000,000 – (($55,000,000 - $33,468,198)*0.35) = $47,463,869.30
Initial Outflow:
Cost of Equipment = $150,000,000
R&D cost = $20,000,000
Test Marketing Cost = $1,000,000
Cost of building = $5,000,000 (Book Value)
Net Working Capital = $15,000,000
So, total outflow = $191,000,000
Year
Basis
%
Depreciation Expense
Accumulated
Depreciation
Ending
Book Value
1
$150,000,000
14.29%
$21,428,571
$21,428,571
$128,571,429
2
$150,000,000
24.49%
$36,734,694
$58,163,265
$91,836,735
3
$150,000,000
17.49%
$26,239,067
$84,402,332
$65,597,668
4
$150,000,000
12.50%
$18,742,191
$103,144,523
$46,855,477
5
$150,000,000
8.93%
$13,387,279
$116,531,802
$33,468,198
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