Project Valuation: (5 points) Miss Foster has just invented a bulletproof earphone. She is considering whether to set up a company, with sole focus on this earphone project. The company would need to immediately buy an automated production machine for $90,000 that would be depreciated over 3 years on a straight-line basis. The production machine is expected to be sold for $10,000 at the end of the 3rd year. She expects that she can sell the product at a price of $100 per unit and that the market size is 950 units in years one and two, and 1,200 units in year 3. After three years, the product will be obsolete and she will close down operations. The company's annual gross margin will be 60% and SG&A/Sales will be 15% per year. She will make an immediate investment in net working capital equal to 15% of next year's expected sales, and she will maintain her level of net working capital each year at 15% of the subsequent year's expected sales. The tax rate is 30%. All cash flows should be assumed to occur at the end of the year and the cost of the production machine occurs today (time 0). After the company closes down, all net working capital is immediately recovered, a cash flow that can be assumed to occur at the end of year 3.

 A.  calculate the free cash flows of the company over the four years (including time 0). 

B. Assuming that Miss Foster's cost of capital is 15%, what is the NPV of the project? Should she go ahead with it? 

C. What is the IRR of the project? Does the IRR rule agree with the NPV rule?

 

 

 

Schedule 2. Shows the computation of Net Present Value. There is a cash outflow of 90,000 in year 0 because of the Production Machine. Year 1 - 3 has Cash inflow computed from schedule 1. Year 1 and Year 2 has a cash outflow of 15 percent of sales because of net working capital investment but will be recovered on year 3 or the total of year 1 and 2. the total or sum of cash inflow and out flow are the free cash flow for the particular year. discount of 15% is use in computing the Present Value. NPV is simply the difference between the PV of Cash Inflow and PV of Cash Outflow. As long as the NPV is positive then the project should have a go.

	Year 0	Year 1	Year 2	Year 3	NET PV
Production Machine	(90,000)			10,000
Cash Inflow from Operations		29,925	29,925	37,800
Net Working Capital Investment		(4,488.75)	(5,670.00)	32,250
Free Cash Flow Per Year	(90,000)	25,436	24,255	80,050
Discount Rate @ 15%	1	0.869565	0.756144	0.657516
PV	(90,000)	22,118	18,340	52,634	3,093
NET TOTAL PV OF CASH FLOW	93,093
Total Investment	(90,000)

Schedule 3. Shows the computation of IRR. IRR is the rate at which the net total cash flow is equal to its initial investment. In this case, using the interpolation method, we have an estimated IRR of 16.7%. In using IRR as a basis, as long as the IRR is greater than the cost of capital then it should have a go. In this case, 16.7% is greater than 15% then its a go and this agree to the NPV earlier that the project should have a go.Ca

	Year 0	Year 1	Year 2	Year 3
Production Machine	(90,000)			10,000
Cash Inflow from Operations		29,925	29,925	37,800
Net Working Capital Investment		(4,488.75)	(5,670.00)	32,250
Free Cash Flow Per Year	(90,000)	25,436	24,255	80,050
Discount Rate @ 16.7	1	0.856898	0.734274	0.629198
PV	(90,000)	21,796.27	17,809.82	50,367.30
TOTAL PV OF CASH INFLOW	89,973
Total Investment	(90,000)
IRR	16.7

Answer rating: 100% (QA)

A To calculate the free cash flows of the company over the four years including time 0 we need to ca... View the full answer