Question

ABC corporation has existing property and equipment that is not in use. The company is considering the use of this property and equipment. One option is to use the property and equipment to produce a new product. Estimates for demand of this product are 30,000 units annually for the first 5 years and 20,000 units annually for the following 6 years. Beyond that, the product is considered to be obsolete and production will cease. Price and variable costs would be $100 and $65, respectively. Fixed costs would be $225,000 per year. If they take this option, they must buy additional equipment for a total of $2 million. This equipment will be depreciated straight-line over a 15 year period of time. When the project is ended (in 11 years), it is expected they will be able to sell the equipment for $130,000. This option also requires an initial net working capital investment of $400,000. This initial NWC investment can be reduced to $300,000 when sales drop (i.e. from year 5 to year 6). The net working capital will be fully recouped at the end of the project. This project is riskier than the average project for the company. Management has determined that the appropriate discount rate to use will be 12%.

a. What is this project’s OCF for years 1-5?

b. What is this project’s OCF for years 6-11?

c. What is this project’s FCF for year 0?

d. What is this project’s FCF for years 1-5?

e. What is this project’s FCF for year 6?

f. What is this project’s FCF for years 7-10?

g. What is this project’s FCF for year 11?

h. What is the project’s NPV?

i. What is the project’s break-even price?

j. Does this company have the internal resources to finance this project?

▪ Yes

▪ No

Answer 1

ABC	0	1-5	6	7-10	11
Investment	-2,000,000					533333.3
Salvage					130,000
NWC	-400,000		100,000		300,000
Sales		3,000,000	2,000,000	2,000,000	2,000,000
VC		-1,950,000	-1,300,000	-1,300,000	-1,300,000
FC		-225,000	-225,000	-225,000	-225,000
Depreciation		-133,333	-133,333	-133,333	-133,333
EBT		691,667	341,667	341,667	341,667
Tax (30%)		-207,500	-102,500	-102,500	-102,500
Profit		484,167	239,167	239,167	239,167
OCF	-400,000	617,500	472,500	372,500	672,500
FCF	-2,400,000	617,500	472,500	372,500	923,500
NPV (12%)	$904,026

Tax rate is not mentioned but it assumed to be 30% here.

Depreciation = Investment / 15

OCF = NWC + Profit + Depreciation

FCF = OCF + Investment + After-tax Salvage Value

NPV can be calculated using calculator given the above cash flows with 12% discount rate.