Question

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%.

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

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

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

10. What is the project’s IRR?

Answer 1

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.