Question

Arnold Inc. is considering a proposal to manufacture​ high-end protein bars used as food supplements by body builders. The project requires use of an existing​ warehouse, which the firm acquired three years ago for $ 4 million and which it currently rents out for $ 134,000. Rental rates are not expected to change going forward. In addition to using the​ warehouse, the project requires an upfront investment into machines and other equipment of $ 1.5 million. This investment can be fully depreciated​ straight-line over the next 10 years for tax purposes. ​ However, Arnold Inc. expects to terminate the project at the end of eight years and to sell the machines and equipment for $ 460,000. ​ Finally, the project requires an initial investment into net working capital equal to 10 percent of predicted​ first-year sales. ​ Subsequently, net working capital is 10 percent of the predicted sales over the following year. Sales of protein bars are expected to be $ 4.9 million in the first year and to stay constant for eight years. Total manufacturing costs and operating expenses​ (excluding depreciation) are 80 percent of​ sales, and profits are taxed at 30 percent.

a. What are the free cash flows of the​ project?

b. If the cost of capital is 15 %​, what is the NPV of the​ project?

Answer 1

a. The warehouse can be rented out again for $135,000 after 8 years

FCF =EBIT (1–t) + Depreciation –CAPX –Change in NWC

FCF in year 0: –1.5m (CAPX) –0.49m (Change in NWC = 10% of sales) = –1.99m

There is no more CAPX nor investment into NWC in years 1 to 7.

Machinery fully depreciated straight-line over the next 10 years = 1.5/ 10 = 0.15 yearly

Book Value after 8 years = .15 * 2 = 0.30

Terminated Cost = 0.46

FCF in year 8: 0.6365 + [0.46 –0.30* (0.46 – 0.30)] + 0.49 = $1.5385m

b. NPV= -1.99 + .6365 for 7years + (1.5385 / (1.15⁸))

= -1.99 + (0.6365/0.15) *(1-((1/(1.15⁷)) + (1.5385 / (1.15⁸))

= -1.99 + 2.648 +0.503

= 1.161m