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.

Problem #3 Expansion Project with MACRS

Consider the expansion project presented in Problem #2.

Instead of straight line depreciation, the company decides to use MACRS 3-year property depreciation schedule given below to improve its NPV.

Year 1 2 3 4

Depreciation Rates 33.33% 44.45% 14.81% 7.41%

(a) Recreate the capital budgeting table of Problem 2(a) with appropriate depreciation.

(b) Write the total after tax cash flows (under MACRS depreciation scenario) in the table below:

Years 0 1 2 3 4 5

Total after-tax

cash flows _____ ____ ____ ____ ____ _____

(c) Calculate the revised NPV for the expansion project using a 10 percent discount rate with MACRS depreciation. Also, calculate the IRR for the same project.

Net Present Value (NPV) __________________________

Internal Rate of Return (IRR) __________________________

(d) Has the company's NPV improved as a result of using a new depreciation schedule? If yes, why do you think it did improve?