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Capital budgeting
- Capital budgeting. Company Inc. is going to invest, based on the marketing research that cost $10,000, into a new project $150,000 with the expectations that this venture will generate sales for the next five years as shown in an exhibit below. Variable cash operating expenses will be 50 percent of sales each year, and fixed cash operating expenses are $20,000 annually. Computation of depreciation is straight-line to zero book value within five year. The income tax rate is 40 percent. The value of the capital investment at the end of year 5 is $15,000 (estimated market value of an investment). The investment also requires additional working capital investments – the company needs to maintain 10% of the annual sales as an investment into working capital (hint: there will be changes in working capital each year). The required rate of return (WACC) is 12 percent.
Estimated sales revenues from an investment
|
Year |
0 |
1 |
2 |
3 |
4 |
5 |
|
Sales |
150 000 |
200 000 |
250 000 |
200 000 |
120 000 |
Questions:
- Compute the incremental cash flows for the project (you are advised to use excel)
- Estimate the NPV and IRR for the project. Should the company invest into this project?
Expert Solution
marketing research cost is already paid and is a sunk cost
Net working capital is assumed to be required at the beginning of the year
The Incremental cashflows are calculated as shown below
| Year | 0 | 1 | 2 | 3 | 4 | 5 |
| Sales | 150000 | 200000 | 250000 | 200000 | 120000 | |
| Less :Variable Costs | 75000 | 100000 | 125000 | 100000 | 60000 | |
| Less: Fixed costs | 20000 | 20000 | 20000 | 20000 | 20000 | |
| Less: Depreciation | 30000 | 30000 | 30000 | 30000 | 30000 | |
| Earnings before tax | 25000 | 50000 | 75000 | 50000 | 10000 | |
| Less: Tax @40% | 10000 | 20000 | 30000 | 20000 | 4000 | |
| Profit after tax | 15000 | 30000 | 45000 | 30000 | 6000 | |
| Add: Depreciation | 30000 | 30000 | 30000 | 30000 | 30000 | |
| Capital Cost | -150000 | |||||
| Net Working capital | 15000 | 20000 | 25000 | 20000 | 12000 | 0 |
| Change in Net working capital | 15000 | 5000 | 5000 | -5000 | -8000 | -12000 |
| After tax Salvage Value | 9000 | |||||
| Incremental Cashflows | -165000 | 40000 | 55000 | 80000 | 68000 | 57000 |
a) Incremental Cashflows for the project for various years of operation are shown in the last row of the table above (Figures in Dollars)
b) NPV of the project = -165000+40000/1.12+55000/1.12^2+80000/1.12^3+68000/1.12^4+57000/1.12^5
=$47060.93
IRR(r) of the project is given by
-165000+40000/(1+r)+55000/(1+r)^2+80000/(1+r)^3+68000/(1+r)^4+57000/(1+r)^5=0
Solving , r=0.2215 or 22.15%
As the NPV is positive as well as the IRR is greater than the WACC, the company should invest in the project
b)
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