Best Manufacturing Company is considering a new investment. Financial projection

Question

Best Manufacturing Company is considering a new investment. Financial projections for the investment are presented in the table below (in beginning of year values so that, for example, "year 1" is the beginning of year 1/end of year 0). The investment costs $12 million and the equipment will have no market value at the end of the five-year project. Assume the corporate tax rate is 34%. Financial details of the Best Manufacturing Company project (in $ thousands) Calculate the risky cash flow (the change in net working capital and the after-tax revenues net of operating costs). Suppose CAPM holds. Assume the company is 100% equity financed with a beta coefficient for the company's stock equal to 1.5. Suppose the riskless interest rate is 3% and the market risk premium is 8%. Assume that the depreciation tax shield is riskless, while changes in net working capital have the same risk characteristics as the operating cash flow. Determine the appropriate discount rate, and hence the NPV, of the risky cash flow. Calculate the NPV of the depreciation tax shield together with the initial investment. Is the project worthwhile?

Explanation / Answer

a) All figure are in thousands

b)

Appropriate Discount rate = risk free rate + marketrisk premium*beta

Appropriate Discount rate = 3 + 8*1.5

Appropriate Discount rate = 15%

NPV of Risky cash flow = -200 + 1930/1.15 + 2590/1.15^2 + 3200/1.15^3 + 3070/1.15^4 + 1950/1.15^5

NPV of Risky cash flow = $ 8265.502009

c) while calculating pv of depreciation tax shield we use riskless rate as mentioned in problem

NPV of depreciation tax shield together with initial investment = -Initial Investment + PV of  depreciation tax shield together

NPV of depreciation tax shield together with initial investment = -12000 + 816*(1-(1+3%)^-5)/3%

NPV of depreciation tax shield together with initial investment = - $ 8262.958935

d) Net Present Value of Project =  NPV of depreciation tax shield together with initial investment + NPV of Risky cash flow

Net Present Value of Project = -8262.958935 + 8265.502009

Net Present Value of Project = $ 2.543074 ( in $ '000)

Net Present Value of Project = $ 2543.07

Decision : Yes the project is worthwile

Year 0 Year 1 Year 2 Year 3 Year 4 Year 5 Sale Revenue [a] 5000 7000 9000 8000 5000 Operating Cost [b] 2000 3000 4000 3500 2500 Investment [c] 12000 Depreciation [d] 2400 2400 2400 2400 2400 Net Working Capital [e] 200 250 300 400 300 0 Depreciation tax shield [ f = d*34%] 816 816 816 816 816 Change in Net working Capital [g] -200 -50 -50 -100 100 300 After Tax revenue net of operating cost [h = (a-b)*(1-34%)] 1980 2640 3300 2970 1650 Risky Cash flow [I = g+h] -200 1930 2590 3200 3070 1950

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