Hi supermom40!!
1. Prepare a statement showing the incremental cash flows for this
project over an 8-year period.
-Initial investment:
The initial investment (I) is the sum of the invest in plant and equipment.
I = $1,000,000
-Working Capital:
The additional net investment in inventory and receivables is the
working capital needed for the project:
WC = $200,000
There is no additional info about the WC, so we can assume that it
will not change over the project's life. Then Working Capital Change
for each year Yi is:
ChWCi = Previous Year WC - Current WC = 0 (for i=1 to 7)
and
ChWC0 = -$200,000
The working capital is recovered, this means that for the end of the
year 8 it will be zero or:
ChWC8 = $200,000
-Depreciation:
For the first five years Yi (i = 1 to 5):
Di = (Invest in plant and equipment)/5 = $1,000,000/5 = $200,000
For the years 6 to 8 the depreciation will be zero.
-Revenues:
For the first year the expected revenues will be:
R1 = $950,000
For the years Yi (i=2 to 8):
Ri = $1,500,000
-Expenses:
Indirect incremental costs will be $80,000 all the eight years.
For each year the direct costs will be 0.55*Ri .
Then for each year Yi (i=1 to 8), the expenses (Ei) will be:
Ei = $80,000 + 0.55*Ri ,
then:
E1 = $80,000 + 0.55*$950,000 = $602,500
For i=2 to 8:
Ei = $80,000 + 0.55*$1,500,000 = $905,000
-Taxes:
The firm's marginal tax rate is 35%, then the taxes will be:
Ti = T * (Ri - Ei - Di) with T = 0.35 (i=1 to 8)
T1 = 0.35*($950,000-$602,500-$200,000) = $51,625
For i=2 to 5
Ti = 0.35*($1,500,000-$905,000-$200,000) = $138,250
For i=6 to 8
Ti = 0.35*($1,500,000-$905,000-$0) = $208,250
Now we can place a cash flows statement (in thousands):
YEARS
0 1 2 3 4 5 6 7 8
1.Revenues 0 950 1500 1500 1500 1500 1500 1500 1500
2.Expenses 0 602.5 905 905 905 905 905 905 905
3.Depreciation 0 200 200 200 200 200 0 0 0
4.Income before 0 147.5 395 395 395 395 595 595 595
tax, [1-(2+3)]
5.Taxes 0 51.6 138.2 138.2 138.2 138.2 238.2 238.2 238.2
6.Net Income 0 95.9 256.8 256.8 256.8 256.8 356.8 356.8 356.8
[4-5]
7.Cash flow
from operation 0 295.9 456.8 456.8 456.8 456.8 356.8 356.8 356.8
[1-2-5]
--------------------------------------------------------------
8.Investments -1000 0 0 0 0 0 0 0 0
9.Change in WC -200 0 0 0 0 0 0 0 200
10.Total cash -1200 0 0 0 0 0 0 0 200
flow from investment
[8+9]
--------------------------------------------------------------
11.Total cash -1200 295.9 456.8 456.8 456.8 456.8 356.8 356.8 556.8
flow [7+10]
The link to the Excel file associated to this answer is:
http://dl1.rapidshare.de/files/1968735/24841164/supermom40.xls
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2. Calculate the Payback Period and the NPV for the project.
-Payback Period:
Payback (PB) calculation will give us an idea on how long it will take
for a project to recover the total initial investment.
Then if:
Y = the year before full recovery of total investment TI;
U = Unrecovered cost at the start of last year;
CFi = CF of the year Y+1;
PB = Y + U/CFi
We will consider the total initial investment (TI) as the sum of the
invest in plant and equipment plus the initial Working Capital
required.
TI = $1,200,000
At the end of the year 2 we have recovered:
$295,875 + $456,750 = $752,625
And U is:
U = $1,200,000 - $752,625 = $447,375 (less than CF3, then Y = 2)
PB = 2 + 447,375/456,750 = 2.98 years or 2 years, 11 months and 23 days.
------------------------
-NPV:
First we need to define the Present Value (PV):
CF1 CF2 CF8
PV = --------- + ---------- + .... + ----------
(1 + R) (1 + R)^2 (1 + R)^8
where R is the required return.
Net Present Value:
NPV = PV - TI where TI = Total Initial Investment
Using a calculator we find that:
PV = $2,229,365.07
NPV = PV - TI = $2,229,365.07 - $1,200,000 = $1,029,365.07
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3. Based on your answer for Q2, do you think the project should be
accepted? Why? Assume Jack and Jill has a policy of not accepting
projects with life of over 3 years.
Definition of Payback Criterion:
-Accept a project if its payback period is less than maximum
acceptable payback period.
-Reject a project if its payback period is longer than maximum
acceptable payback period.
The payback period is less than the 3 years, then the project fits the
limit policy of Jack and Jill Manufacturing, then the project is
acceptable by this criterion.
The NPV is positive and very atractive. The NPV criterion has considerable merits:
- it takes in to account the time value of money
- it considers the cash flow stream in its project life
The NPV Decision Rule says:
-Accept a project if NPV >= 0.
So by this criterion the project is also acceptable.
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4. If the project required additional investment in land and building,
how would this affect your decision? Explain.
Additional investment in land and building is a relevant cash flow, so
it must be added to the initial investment, and depending on the
amount of money invested on this topic the NPV could become negative
and in that case the project will be rejected via the NPV criterion.
Also note that the current payback period is very close to the limit
of 3 years, so any additional investment will increase the payback
period to a number greater than 3 and the project will be rejected,
despite of the possibility that the NPV remains positive.
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I hope that this helps you. Before rate this answer, if you find
something unclear use the clarification feature and I will gladly
clarify and/or correct it. Until you feel satisfied with this answer I
will respond to all your requests for further assistance on this
topic.
Best regards.
livioflores-ga |
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