Question

All Green Inc.plans a capital project, where it requiresan asset that costs $120,000. It has an expectedeconomic life of 3years. The asset will be depreciated using the straight-line method to $0book value.Thecompany expects thatthe assetwill be worth $30,000at the end of the project. Incremental salesare expected to be $100,000, $110,000, and120,000 for year 1 to 3, respectively.Correspondingexpenses are expected to be 50% of the sales.The company will need to invest $12,000 at time=0innet working capital, which will increase $1,000 each year.The cost of capital is 12% and thecorporate tax rate is 40%.Develop the cash flows for the project. What are its NPV, IRR,andMIRR?Interpret the results in your own words.
Annual Depreciation = 120,000/3 = 40,00
Initial Investment: 120,000+12,000 = 132,000.

OCF1= 100,000*(.5)*(1-.4) + 40,000*.4 = 46,000;
OCF2= 110,000*(.5)*(1-.4) + 40,000*.4 = 49,000
OCF3= 120,000*(.5)*(1-.4) + 40,000*.4 = 52,000
NWC Investment = 1000 for t=1, 2.

Terminal CF = 14,000 +30000*(1-.4) = 32000
NCF1= 46000- 1000 = 45,000
NCF2= 49000 – 1000 = 48,000
NCF3= 52000 + 32000 = 84,000

NPV = -132000 + 45000/1.12 + 48000/1.122+84000/1.123= 6,233.42
IRR = -132 + 45/(1+ IRR) +48/(1+IRR)2+ 84/(1+IRR)3= 0 and solve for IRR; IRR =14.14%
MIRR =13.74%

2.Suppose All Greens Inc. in Question 1 above realizes that it will have to use a building that it bought 15 years ago for $150,000.
This building is worth $200,000 today. It also spent $80,000 in R&D to develop the new product. How do these change the cash flows?

Answer 1

Building is already purchased for $150,000, hence it will not affect the decision. Also the already spent $80,000 is the sunk cost for the company as it is already incurred and will not affect the decision making.

The building can be sold for $200,000 today and if the company decides to go with the project, it will avoid $200,000 hence this is the opportunity cost of the project.

After tax amount = $200,000 (1 - .4) = $120,000

This will be treated as cashoutflow at t=0 and cash inflow at t=3 assuming that the building will be sold after 3 years.

So, the initial investment will increase by $120,000 making it $252,000 and NCF3 will increase by $120,000 making it $204,000

NPV will be $55,358.25