Question 10CRS-TP1: Based on the following information for Project X, should we ...
Based on the following information for Project X, should we undertake the venture? To answer, first prepare a pro forma income statement for each year. Next, calculate operating cash flow. Finish the problem by determining total cash flow and then calculating NPV assuming a 28 percent required return. Use a 34 percent tax rate throughout. For help, look back at our shark attractant and power mulcher examples.
Project X involves a new type of graphite composite in-line skate wheel. We think we can sell 6,000 units per year at a price of $1,000 each. Variable costs will run about $400 per unit, and the product should have a four-year life.
Fixed costs for the project will run $450,000 per year. Further, we will need to invest a total of $1,250,000 in manufacturing equipment. This equipment is seven-year MACRS property for tax purposes. In four years, the equipment will be worth about half of what we paid for it. We will have to invest $1,150,000 in net working capital at the start. After that, net working capital requirements will be 25 percent of sales.
To develop the pro forma income statements, we need to calculate the depreciation for each of the four years. The relevant MACRS percentages, depreciation allowances, and book values for the first four years are:
|
Year |
MACRS Percentage | Depreciation | Ending Book Value |
| 1 | 14.29% | .1429 × $1,250,000 = $178,625 | $1,071,375 |
| 2 | 24.49 | .2449 × 1,250,000 = 306,125 | 765,250 |
| 3 | 17.49 | .1749 × 1,250,000 = 218,625 | 546,625 |
| 4 | 12.49 | .1249 × 1,250,000 = 156,125 |
390,500 |
The projected income statements, therefore, are as follows :
| Year | ||||
| 1 | 2 | 3 | 4 | |
| Sales | $6,000,000 | $6,000,000 | $6,000,000 | $6,000,000 |
| Variable costs | $2,400,000 | 2,400,000 | 2,400,000 | 2,400,000 |
| Fixed costs | 450,000 | 450,000 | 450,000 | 450,000 |
| Depreciation | 178,625 | 306,125 | 218,625 | 156,125 |
| EBIT | $2,971,375 | $2,843,875 | $2,931,375 | $2,993,875 |
| Taxes (34%) | – 1,010,268 | – 966,918 | – 996,668 | – 1,017,918 |
| Net income | \underline{\underline{\$ 1,961,108}} | \underline{\underline{\$ 1,876,958}} | \underline{\underline{\$ 1,934,708}} | \underline{\underline{\$ 1,975,958}} |
Based on this information, the operating cash flows are:
|
Year |
||||
|
1 |
2 |
3 |
4 |
|
| EBIT |
$2,971,375 |
$2,843,875 |
$2,931,375 |
$2,993,875 |
| Depreciation |
178,625 |
306,125 |
218,625 |
156,125 |
| Taxes |
– 1,010,268 |
– 966,918 |
– 996,668 |
– 1,017,918 |
| Operating cash flow |
\underline{\underline{\$ 2,139,732}} |
\underline{\underline{\$ 2,183,082}} |
\underline{\underline{\$ 2,153,332}} |
\underline{\underline{\$ 2,132,082}} |
We now have to worry about the nonoperating cash flows. Net working capital starts out at $1,150,000 and then rises to 25 percent of sales, or $1,500,000. This is a $350,000 change in net working capital.
Finally, we have to invest $1,250,000 to get started. In four years, the book value of this investment will be $390,500, compared to an estimated market value of $625,000 (half of the cost). The aftertax salvage is thus $625,000 – .34 × ($625,000 – 390,500) = $545,270.
When we combine all this information, the projected cash flows for Project X are:
|
Year |
|||||
|
0 |
1 |
2 |
3 |
4 |
|
| Operating cash flow |
$2,139,732 |
$2,183,082 |
$2,153,332 |
$2,132,082 |
|
| Change in NWC |
– $1,150,000 |
– 350,000 |
1,500,000 |
||
| Capital spending |
– 1,250,000 |
545,270 |
|||
| Total cash flow | – \underline{\underline{\$ 2,400,000}} |
\underline{\underline{\$ 1,789,732}} |
\underline{\underline{\$ 2,183,082}} |
\underline{\underline{\$ 2,153,332}} |
\underline{\underline{\$ 4,177,352}} |
With these cash flows, the NPV at 28 percent is:
NPV = –$2,400,000 + 1,789,732/1.28 + 2,183,082/1.28² +
2,153,332/1.28³ + 4,177,352/1.28⁴
= $2,913,649
So this project appears quite profitable.