Your employer, Capital Corp., is considering a project to install a new manufact

Question

Your employer, Capital Corp., is considering a project to install a new manufacturing line, at a cost of $4 million. The line will be installed area of the factory that was refurbished in 2008; the refurbishment cost of $750,000. The line will be depreciated on a straight-line basis over a five year period to a salvage value of $0. If implemented, the project will cause an immediate increase in Inventory of $200,000. It will also cause immediate increases in Accounts Receivable of $300,000, Accounts Payable of $150,000, and Long-Term Debt of $3 million. If implemented, the project is expected to generate annual sales of $3,500,000 during each of the next five years. In addition, it is expected to generate combined COGS and SG&A; expense of $2 million per year. At the end of the project's five-year life, production will cease, and the manufacturing line will be sold for an estimated $100,000. At that time, Inventory, Accounts Receivable and Accounts Payable will return to their pre-project levels Capital's marginal and average tax rate is 35%. The firm has 1 million shares of common stock outstanding. The firm requires a 12% rate of return on capital projects. Prepare a discounted cash flow analysis to determine whether your employer should implement this capital project. Your analysis should provide answers to each of the following questions 1. What is the project's initial investment? 2. What are the future annual incremental operating cash flows? 3. What is the terminal cash flow? 4. What is the NPV? 5. What is the IRR? 6. Should Capital implement the project? Why or why not 7. If Capital implements the project, what will be the impact on the stock price?

Explanation / Answer

B C D E F G H I 1 1 Initial Investment - 2 Cost of machine (Total cost - Debt financing) 1000000 3 Refabrication cost 750000 4 Increase in Net Working capital - 5 Increase in Inventory 200000 6 Increase in Account recievables 300000 7 Less: Increase in Accounts payable 150000 350000 8 2100000 9 =SUM(H3:H8) 10 2 Calculation of Annual operating cash flows 11 Inremental sales 3500000 12 Incremental expenses 2000000 13 Incremental Contribution 1500000 14 Less: Depreciation (4m/5) 800000 15 Incremental EBIT 700000 16 Less Tax @ 35% 245000 17 PAT 455000 18 Add: Depreciation 800000 19 OCF 1255000 20 21 3 Terminal cash flows 22 Post tax salvage value (100000 x (1-0.35)) 65000 23 Recovery of NWC 350000 24 415000 25 26 4 NPV - 0 1 to 4 5 27 Initial Investments -2100000 28 OCF 1255000 1255000 29 Terminal Cash flows 415000 30 Net Cash flows -2100000 1255000 1670000 31 PV factors @ 12% 1 3.0373 0.567427 32 =-PV(12%,4,1) =1/1.12^H27 33 PV of cash flows -2100000 3811873 947602.8 34 NPV = 2659476 35 5 IRR =SUM(F34:H34) 36 Year Cash Flow PV Factors Present value 37 54% 55% 54% 55% 38 0 -2100000 1 1 -2100000 -2100000 39 1 1255000 0.649351 0.645161 814935.1 809677.4 40 2 1255000 0.421656 0.416233 529178.6 522372.5 41 3 1255000 0.273803 0.268537 343622.5 337014.5 42 4 1255000 0.177794 0.17325 223131.5 217428.7 43 5 1670000 0.115451 0.111774 192802.6 186662.9 44 3670.225 -26843.9 45 46 r= NPV = 47 54% 3670.225 48 r 0 49 55% -26843.9 50 51 r-54/55-54 = (0-3670.225)/(-26843.9-3670.225) 52 r-54 = 0.12028 x 1 53 r = 54 + 0.12028 = 54 r = 54.12028 or ose IRR formula i.e. 55 Approx 54.12% =IRR(D39:D44) 56 57 6 Project should be implemented as its NPV is positive also IRR is more then Required rate. 58 7 If we accept the project, it will improve the earning capacity of company and hence would result in higher price. 59 60 Please provide feedback…. Thanks in advance…. :-)

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