Drilling-Easy (DE) Inc. currently has two products, low-priced drills and a line

Question

Drilling-Easy (DE) Inc. currently has two products, low-priced drills and a line of smart drill bits. DE Inc. has decided to sell a new line of high-priced drills. Sales for the new line of drills are estimated at $27 million a year. Annual variable costs are 60% of sales. The project is expected to last 5 years. In addition to the production variable costs, the fixed costs each year will be $2,000,000. The company has spent $1,500,000 in a marketing and research study that determined the company will gain $10 million in sales a year of its existing line of smart drill bits. The production variable cost of these sales is $8 million a year. The plant and equipment required for producing the high-priced drills costs $11,000,000 and will be depreciated down to zero over 20 years using straight-line depreciation. It is expected that the plant and equipment can be sold for $4,000,000 at the end of the project. The project will also require an increase in net working capital of $3,000,000 today that will be returned at the end of the project. The tax rate is 30 percent and the require rate of return for this project is 16%.

Please Show Work

What is the initial outlay (IO) for this project?

What is the operating cash flows (OCF) for each of the years for this project?

What is the termination value (TV) cash flow (aka recovery cost or after-tax salvage value, or liquidation value of the assets) at the end of the project?

What is the NPV of this project?

Explanation / Answer

New Drill Sales     2,70,00,000 Variable Cost Annual     1,62,00,000 Fixed Cost         20,00,000 Annual Gain         88,00,000 Life of Project (Years)                          5 Existing Sale     1,00,00,000 Existing Variable Cost         80,00,000 Market Study       (15,00,000) Historical Cost, not required for evaluation of the project Equipment required (1,10,00,000) Increase in Working Capital       (30,00,000) years for Depn                       20 Salvage Value         40,00,000 Release of working Capital at the end of the project         30,00,000 Tax Rate 30% MARR 16% Depreciation P.A.) =11000000/20           5,50,000 (a) Initial Outlay of the project Equipment required (1,10,00,000) Increase in Working Capital       (30,00,000) Total (A) (1,40,00,000) (b) Calculation of OCF each Year Annual Gain         88,00,000 Less: Depn.           5,50,000 Taxable Income         82,50,000 Less:Tax at 30%         24,75,000 Net Income         57,75,000 Add: Depn           5,50,000 OCF Each Year         63,25,000 (c ) Terminal Value Salvage Value         40,00,000 Tax Saving on Loss         12,75,000 Release of working Capital at the end of the project         30,00,000 Total         82,75,000 Tax Saving on Loss of Assets Cost of Assets     1,10,00,000 Less: Depn Charged         27,50,000 Book Value at the end of project         82,50,000 Less: Salvage value         40,00,000 Loss On Sale of Assets         42,50,000 Tax Saving on Loss of Assets         12,75,000 (d) NPV of the Project Annual OCF         63,25,000 Disc Factor          3.274294 PV of Annual OCF (B)     2,07,09,907 Terminal Value         82,75,000 Disc Factor          0.476113 PV of Annual OCF (C )         39,39,835 Initial Outlay (A) (1,40,00,000) NPV of the Project (B+C-A)     1,06,49,743 Since NPV is >0, So project is acceptable Calculation of Discount Factor 1/(1+.16)^n 1          0.862069 2          0.743163 3          0.640658 4          0.552291 5          0.476113 Total          3.274294

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