Question

# The Virginia Cane Company (VCC) is considering investing in a new cane manufacturing machine that has...

The Virginia Cane Company (VCC) is considering investing in a new cane manufacturing machine that has an estimated life of 4 years. The cost of the machine is \$50,000 and the machine will be depreciated straight-line over its 4-year life to a salvage value of \$0. While the machine will be fully depreciated over the project’s life, management thinks the cane machine can be sold for \$3,000, excluding applicable tax, at project end.

In the first year, VCC expects to sell 2,500 canes. The number of canes sold each year is estimated to grow by 10%. VCC forecasts that the sale price of \$18 per cane will remain unchanged over the life of the project. The firm’s total cost to make each cane, not including depreciation, is \$9 per cane, and this cost is expected to remain unchanged over the life of the project.

Installation of the machine and the resulting increase in sales will require increases in working capital. ABC is budgeting that working capital needs each year will be 10% of the next year’s revenues. The firm faces a marginal tax rate of 35% and a discount rate of 11%.

1. What is the project’s total cash flow for year 0?

2. What is the amount that must be additionally invested in working capital at end of year 1?

3. What is the project’s total cash flow for year 4?

10. What is the project’s IRR?

 VCC 0 1 2 3 4 Unit Sales 2,500 2,750 3,025 3,328 Investment -50,000 NWC -4,500 -450 -495 -545 5,990 Salvage 3,000 Sales 45,000 49,500 54,450 59,895 Costs -22,500 -24,750 -27,225 -29,948 Depreciation -12,500 -12,500 -12,500 -12,500 EBT 10,000 12,250 14,725 17,448 Tax (35%) -3,500 -4,288 -5,154 -6,107 Net Income 6,500 7,963 9,571 11,341 Cash Flows -54,500 18,550 19,968 21,527 31,780 IRR 22.29%

NWC = 10% x Sales and incremental NWC is difference in NWC, and all of NWC will be recovered at the end.

Depreciation = Investment / No. of years

Cash Flows = Investment + NWC + Net Income + Depreciation + Salvage x (1 - tax)

IRR can be calculated using the same function in excel or calculator given the above cash flows.

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