You are Head of the capital budgeting team of your company. Your company is eval
ID: 2766669 • Letter: Y
Question
You are Head of the capital budgeting team of your company. Your company is evaluating a new project -- to produce plastic food containers that resist stains and odors. The plastic material was discovered last year after the company spent $3 million on research and development. If the new product is launched, the company will have to purchase land, estimated for $750,000, and build a new plant and equipment, estimated for $1.5 million. Sales of the new product are forecasted at $2 million for year 1 and costs at $1 million. Both sales and costs are expected to increase by 5% per year. Throughout the project, working capital including inventories and raw materials is forecasted at 20% of sales of the following year (e.g., NWC0 = 20% * Sales1 and so on).
The project will last five years. After that, the company expects to sell the licensing fee for $2 million, the land for $1,000,000 and the plant and equipment for $500,000. The depreciation for the land, plant and equipment falls under 5-year MACRS with the following rates:
Year
1
2
3
4
5
6
Rate
20%
32%
19.2%
11.52%
11.52%
5.76%
If the cost of capital is 15% and the tax rate is 35%, should the company accept the project? What is NPV of the project?
Year
1
2
3
4
5
6
Rate
20%
32%
19.2%
11.52%
11.52%
5.76%
Explanation / Answer
Total cost of project = $3 Mn +$1.5+ $.75 =$5.25 Mn
Book Value at the end = remainig depreciable value =5.76% of 5.25 =$.3024
Total market value of all things $2+$1 +.5 =$3.5Mn
Total cashflows from residual value after tax =3.5 -0.35*(3.5 - 0.3024) =2.38
NPV is present value of cashflows at discount of 15%
=-5.65 + 0.98/(1.15) +1.03/(1.15)^2 + 3.87/(1.15)^5
which come to be -0.76
Total cost of project 5.25 P&L Sales 2.00 2.10 2.21 2.32 2.43 Cost 1.00 1.05 1.10 1.16 1.22 Depreciation 20% 32% 19.20% 11.52% 11.52% Depreciation 1.05 1.68 1.01 0.60 0.60 PBT -0.05 -0.63 0.09 0.55 0.61 Tax 0.00 0.00 0.03 0.19 0.21 PAT -0.05 -0.63 0.06 0.36 0.40 PAT+ Dep 1.00 1.05 1.07 0.96 1.00 WC deployed 0.40 0.42 0.44 0.46 0.49 0.00 Incremental WC 0.40 0.02 0.02 0.02 0.02 Release of WC 0.49 Initial Investment 5.25 Cashflows from sellingland , equipment 2.38 Total Cashflows
(Pat+Dep - Incremental WC -Initia investment + residual cashflows -5.65 0.98 1.03 1.05 0.94 3.87 -0.76
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