Question

Unfortunately, the contractor working on the original equipment has gone broke and will be unable to complete the assembly of the equipment. To date $200,000 in progress payments have been made and will not be recoverable. These costs have been expensed. However, with in-house expertise the equipment for the project could be completed almost immediately at a further cost of $600,000. If the project proceeds, an overhaul of the equipment will be required at the end of year 4 for $200,000. All the equipment could be salvaged for $25,000 when the project is completed at the end of year 9. The equipment will be put into use immediately, but will not begin to generate revenue until year 2. During year 1, cash expenses of $225,000 will be incurred. The project will generate yearly revenues of $550,000 for years 2 – 9 inclusive. Cash expenses would be $220,000 per year for years 2 – 9 inclusive. If they embark on this project, Cavendish Corporation will need to increase its inventory and accounts receivable [working capital] by $35,000, immediately. CCA Rate: 30% Tax Rate: 40% WACC: 10% Required: Using the NPV approach, determine if Cavendish should proceed with this investment? Show all of your calculations.

Answer 1

Initial (0) year

cost of progress payment should be expensed at the 0th year = $ 200000

Tax benefits from the above expense (as cash infow)= 200000*40%= $ 80000

net effect of the above expeses = (200000 - 80000) = $ 120000 (outflow)

Project initial investment(for equipment) as further cost of 0th year = $ 600000 (outflow)

Net increase in working capital (inventory and receivables) = $ 35000 (outflow)

Net initial investment = 120000 + 600000+ 35000 = $ 755000

	0 year	year 1	year 2	Year 3	Year 4	Year 5	Year 6	Year 7	Year 8	Year 9
Investment	($755000) (calculation is above)				($200000) This is the additional cost ofequipment)
Increase in Revenue			$ 550000	$550000	$ 550000	$550000	$550000	$550000	$550000	$550000
- Increase in cash expenses		($225000)	($220000)	($220000)	($220000)	($220000)	($220000)	($220000)	($220000)	($220000)
= Operating cash flow (not considering depreciation)		($225000)	$330000	$330000	$330000	$330000	$330000	$330000	$330000	$330000
- Increase in tax expenses @ rate of 40%		90000 (this is tax benefit)	(132000)	(132000)	(132000)	(132000)	(132000)	(132000)	(132000)	(132000)
= Operating cash flow (not considering depreciation) after tax expenses		(135000)	198000	198000	198000	198000	198000	198000	198000	198000
+ Depreciation tax shield: net increase in depreciation expense for tax purposes × tax rate @ 25% = (table 2 below)		=20000	=20000	=20000	=20000	=32000	=32000	=32000	=32000	=32000
= Incremental net operating cash flow for the period		=(115000)	= 218000	= 218000	= 218000	=230000	=230000	=230000	=230000	=230000
+ Release of working capital										= 35000
+Terminal incremental cash flow from disposal (calculation is below****)										= $ 15000
Net incremental cash flow	($755000)	= ($115000)	=$ 218000	=$218000	=$218000-200000 =$ 18000	=$230000	=$230000	=$230000	=$230000	=$230000+ 35000+15000 =$ 280000
*PV factor @$1 k=10%	1	(1/1+10%)1 = 0.909	(1/1+10%)2 = 0.826	(1/1+10%)3 = 0.751	(1/1+10%)4 = 0.683	(1/1+10%)5 = 0.621	(1/1+10%)6 = 0.564	(1/1+10%)7 = 0.513	(1/1+10%)8 = 0.467	(1/1+10%)9 = 0.424
=PV of Net Incre. CF	($755000)	($104535)	$180068	$163718	$12294	$142830	$129720	$117990	$107410	$118720

NPV = Pv cash inflow - pv of cash outflow

Pv cash inflow = 972750 (adding remining present values of year 2 to year 9)

-pv of cash outflow = 755000 + 104535 = 859535

NPV = 972750 - 859535 = $ 113,215

conclusion

>>Using the NPV method the Cavendish accept the project because NPV of this project is psitive. If the NPV of a project is positive, the project will add value to the business.

Table 2 - Depreciation schedule( there is no spesific the methode so, we take the stright line method)

Year	1	2	3	4	5	6	7	8	9
Equi. cost = 600000 / 9 = 6666.7 each year	66666.7	66666.7	66666.7	66666.7	66666.7	66666.7	66666.7	66666.7	66666.7
Equi addition $200000 at starting end of 4th year to 9 the year by 5year stright lin					200000/5 =40000	=40000	=40000	=40000	=40000
Total dep.	66666.7	66666.7	66666.7	66666.7	106667	106667	106667	106667	106667
Depreciation tax shield here the CCArate=30	66666.7*30% =20000	66666.7*30% =20000	66666.7*30% =20000	66666.7*30% =20000	106667*30% = 32000	106667*30% = 32000	106667*30% = 32000	106667*30% = 32000	106667*30% = 32000

****Terminal cash flow

salvage value = 25000

carrying value at the end of 9th year is zero for all equipment

so the full salvage value is gain and give the tax expenses on gain at rate of 40% = 25000*40% = 10000

net cash inflow from diposal of asset = 25000 - 10000 = $ 15000 =Terminal cash flow from disposal