Problem #2 Expansion Project

Consider the following expansion project which requires an initial investment outlay of $350,000 in fixed capital items. This outlay includes $75,000 for non-depreciable land, plus $275,000 for equipment that will be depreciated straight line to zero over five years. The investment in net working capital is the net investment in short-term assets required for the investment. This is the investment in receivables and inventory needed, less the short-term payables generated by the project. In this case, the project required $120,000 of current assets but generated $40,000 in current liabilities, resulting in a total investment in net working capital of $80,000. Hence, the total investment outlay at time zero is $430,000. Each year, sales will be $380,000 and cash operating expenses will be $130,000. Annual depreciation for the $275,000 depreciable equipment is $55,000 (one-fifth of the cost). The result is an operating income before taxes of $195,000. Income taxes at a 40 percent rate are 0.40 $195,000 = $78,000. This leaves operating income after taxes of $117,000. Adding back the depreciation charge of $55,000 gives the annual after-tax operating cash flow of $172,000. At the end of Year 5, the company will sell off the fixed capital assets. In this case, the fixed capital assets (including the land) are sold for $125,000, which represents a gain of $50,000 over the remaining book value of $75,000. The gain of $50,000 is taxed at 40 percent, resulting in a tax of $20,000. This leaves $105,000 for the fixed capital assets after taxes. Additionally, the net working capital investment of $80,000 is recovered, as the short-term assets (such as inventory and receivables) and short-term liabilities (such as payables) are no longer needed for the project. Total terminal year non-operating cash flows are then $185,000. Assume that the investment project has a required rate of return of 10 percent.

(a) Create a capital budgeting cash flow table.

(b) Write the total after tax cash flows in the table below:

Years 0 1 2 3 4 5

_______________________________________________

Total After-tax

cash flows

(c) Calculate the NPV for the expansion project by discounting the future cash flows at 10 percent and subtracting the investment outlay. Also calculate the IRR for the same project. You can make use of a financial calculator or MS Excel formulas for these calculations.

Net Present Value (NPV) _______

Internal Rate of Return (IRR) __________

(d) How would your answer to part (c) change if annual sales are $420,000 instead of $390,000?

Net Present Value (NPV)_______

Internal Rate of Return (IRR)__________

(e) How would your answer to part (c) change if annual sales are still $390,000 and yet the discount rate is 9%?

Net Present Value (NPV) __________________________

Internal Rate of Return (IRR) ________

(f) How would your answer to part (c) change if annual sales and discount rate are still $390,000 and 10% respectively, and yet tax rate is 30% instead of 40%?

Net Present Value (NPV) __________________________

Internal Rate of Return (IRR) _______________________