Calculate the cash flows and its NPV and IRR for each question.

Practice 1A

Project Information:

• Cost of equipment = $400,000

• Shipping & installation will be $20,000

• $25,000 in net working capital required at setup

• 3-year project life, 5-year class life

• Simplified straight line depreciation

• Revenues will increase by $220,000 per year

• Defects costs will fall by $10,000 per year

• Operating costs will rise by $30,000 per year

• Salvage value after year 3 is $200,000

• Cost of capital = 12%, marginal tax rate = 34%

Practice 1B

Project Information:

• For the same project, suppose we can only get $100,000 for the old equipment after year
3, due to rapidly changing technology.

• Calculate the IRR and NPV for the project.

• Is it still acceptable?
Practice 2

Automation Project:

• Cost of equipment = $550,000

• Shipping & installation will be $25,000

• $15,000 in net working capital required at setup

• 8-year project life, 5-year class life

• Simplified straight line depreciation

• Current operating expenses are $640,000 per yr.

• New operating expenses will be $400,000 per yr.

• Already paid consultant $25,000 for analysis.

• Salvage value after year 8 is $40,000

• Cost of capital = 14%, marginal tax rate = 34%

SOLUTION

Practice 1A
Initial Outlay:
(400,000) Cost of asset
+ ( 20,000) Shipping & installation
(420,000) Depreciable asset
+ ( 25,000) Investment in NWC
($445,000) Net Initial Outlay

Annual Cash Flow for Years 1-3

220,000 Increased revenue
10,000 Decreased defects
(30,000) Increased operating costs
(84,000) Increased depreciation  (420,000/5 years= 84,000)
116,000 EBT
(39,440) Taxes (34%)
76,560 EAT
84,000 Depreciation reversal
160,560 = Annual Cash Flow

Terminal Cash Flow

Salvage value = $200,000
Book value = depreciable asset - total amount depreciated.
Book value = $168,000  (420,000 – 252,000)
Capital gain = SV - BV = $32,000
Tax payment = 32,000 x .34 = ($10,880)

200,000 Salvage value

(10,880) Tax on capital gain
25,000 Recapture of NWC
214,120 Terminal Cash Flow

NPV and IRR:

CF (0) = -445,000
CF (1), (2) = 160,560
CF (3) = 160,560 + 214,120 = 374,680
Discount rate = 12%

Year Cash Flow PV @ 12%

0 (445,000)
1 160,560 143,364.024
2 160,560 127,998.432
3 374,680 266,697.224
Total PV 538,059.68

IRR = 22.1%
NPV = $93,059.68 Accept the project!

Practice 1B

Terminal Cash Flow:

Salvage value = $100,000
Book value = depreciable asset - total amount depreciated.
Book value = $168,000.
Capital loss = SV - BV = ($68,000)
Tax refund = 68,000 x .34 = $23,120

Terminal Cash Flow:

100,000 Salvage value
23,120 Tax on capital gain
25,000 Recapture of NWC
148,120 Terminal Cash Flow

NPV and IRR:

CF (0) = -445,000
CF (1), (2) = 160,560
CF (3) = 160,560 + 148,120 = 308,680
Discount rate = 12%

Year Cash Flow PV @ 12%

0 (445,000)
1 160,560 143,364.024
2 160,560 127,998.432
3 308,680 219,718.424
Total PV 491,080.88

IRR = 17.3%
NPV = $46,080.88. Accept the project!

Practice 2
Initial Outlay:
(550,000) Cost of new machine
+(25,000) Shipping & installation
(575,000) Depreciable asset
+(15,000) NWC investment
(590,000) Net Initial Outlay

Annual Cash Flow for Years 1-5

240,000 Cost decrease
(115,000) Depreciation increase (575,000/5=115,000)
125,000 EBIT
(42,500) Taxes (34%)
82,500 EAT
115,000 Depreciation reversal
197,500 = Annual Cash Flow

Annual Cash Flow for Years 6-8

240,000 Cost decrease
(0) Depreciation increase
240,000 EBIT
(81,600) Taxes (34%)
158,400 EAT
(0) Depreciation reversal
158,400 = Annual Cash Flow

Terminal Cash Flow:

40,000 Salvage value
(13,600) Tax on capital gain
15,000 Recapture of NWC
41,400 Terminal Cash Flow

NPV and IRR:

CF (0) = -590,000
CF (1 - 5) = 197,500
CF (6 - 7) = 158,400
CF (8) = 158,400 + 41,400 = 199,800
Discount rate = 14%

Year Cash Flow PV @ 14%

0 (590,000)
1 197,500
2 197,500
3 197,500
4 197,500
5 197,500 678,037.25
6 158,400 72,167.04
7 158,400 63,296.64
8 199,800 70,049.88
Total PV 883,550.81

IRR = 28.13% NPV = $293,550.81

We would accept the project!