lech Inc. is considering to introduce a new product with a three year life. The
ID: 2806145 • Letter: L
Question
lech Inc. is considering to introduce a new product with a three year life. The company will need an equipment that cost $4 million and will be depreciated straight line to zero over its three-year tax life. The equipment will have a market value of $200,000 at the eend of the project. Projected units sold are 100,000 for each of the three years and the 0 company expects to charge a price of $25 per unit. Variable costs are estimated at $10 per dles unit and fixed costs at $200,000 for each of the three years of the life of the product. The project requires an initial investment in networking capital of $300,000. If the tax rate is 35 percent and the discount rate is 10%, what is the OCF of this project? What is the NPV?Explanation / Answer
Calculation of Depreciation = (Cost of asset – expected salvage value)/ Life of the asset
= ($4,000,000 – 0)/ 3
= $1,333,333.33
Net Salvage value = Market value of asset – (Market value of asset – book value) x tax rate
= $200,000 – ($200,000-0) x 35%
= $130,000
Annual Revenue = 100,000 x $25 = $2,500,000
Annual Variable Expenses = 100,000 x $10 = $1,000,000
Year
0
1
2
3
Cost of asset
-4000000
Working capital investment
-300000
Annual Revenue
2500000
2500000
2500000
Annual Variable Expenses
-1000000
-1000000
-1000000
Annual Fixed expenses
-200000
-200000
-200000
Annual Depreciation
-1333333
-1333333
-1333333
EBIT
-33333.3
-33333.3
-33333.3
Taxes 35%
11666.67
11666.67
11666.67
(+) Depreciation
1333333
1333333
1333333
OCF
1311667
1311667
1311667
Net Salvage value
130000
working Capital recovered
300000
Free cash flow
-4300000
1311667
1311667
1741667
Calculation of NPV
NPV is the sum of PV of cash flows
Year
0
1
2
3
Free Cash flow
-4300000
1311667
1311667
1741667
PV Factor @10%
1.000000
0.909091
0.826446
0.751315
PV
-4300000
1192424
1084022
1308540
NPV
-715014
Therefore, NPV of this project would be -$715014 and this project would be rejected.
Year
0
1
2
3
Cost of asset
-4000000
Working capital investment
-300000
Annual Revenue
2500000
2500000
2500000
Annual Variable Expenses
-1000000
-1000000
-1000000
Annual Fixed expenses
-200000
-200000
-200000
Annual Depreciation
-1333333
-1333333
-1333333
EBIT
-33333.3
-33333.3
-33333.3
Taxes 35%
11666.67
11666.67
11666.67
(+) Depreciation
1333333
1333333
1333333
OCF
1311667
1311667
1311667
Net Salvage value
130000
working Capital recovered
300000
Free cash flow
-4300000
1311667
1311667
1741667
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