Question

The Movie Place is considering a new investment whose data are shown below. The required

equipment costs $65 000 and would be depreciated by the straight line method over the three years

of its use. It would have a positive salvage value of $5 000 at the end of Year 3, when the project

would be closed down. Also, $10 000 in new working capital would be required, but it would be

recovered at the end of the project's life. Revenues will be $70 000. Operating costs excluding

depreciation will be $25 000, and these other operating costs are expected to be constant over the

project's 3-year life. The firm’s tax rate is 30% and the opportunity cost of capital for this type of

project is 12%.

Formulas are provided on the last pages of this question booklet.

Required:

Show your workings!

a.

What is the project's NPV?

b.

Should they proceed with the project? Why or why not?

Answer 1

1.
Cash flow at time zero=-Initial Investment-Investment in Working Capital=-65000-10000=-75000.00

Depreciation=(Initial Cost-Salvage Value)/t=(65000-5000)/3=20000.00

Operating cash flow=(Revenues-Operating Costs-Depreciation)*(1-tax rate)+Depreciation=(70000-25000-20000)*(1-30%)+20000=37500.00

Terminal cash flow except operating cash flow=Working Capital+Salvage Value=10000+5000=15000.00

NPV=Present value of all cash flows=-75000.00+37500.00/12%*(1-1/1.12^3)+15000.00/1.12^3=25745.3762755

2.
As NPV is positive, accept the project because it adds value to the firm