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Homework answers / question archive / United Pigpen is considering a proposal to manufacture high-protein hog feed
United Pigpen is considering a proposal to manufacture high-protein hog feed. The project would make use of an existing warehouse, which is currently rented out to a neighboring firm. The next year’s rental charge on the warehouse is $105,000, and thereafter, the rent is expected to grow in line with inflation at 4% a year. In addition to using the warehouse, the proposal envisages an investment in plant and equipment of $1.23 million. This could be depreciated for tax purposes straight-line over 10 years. However, Pigpen expects to terminate the project at the end of 8 years and to resell the plant and equipment in year 8 for $410,000. Finally, the project requires an immediate investment in working capital of $355,000. Thereafter, working capital is forecasted to be 10% of sales in each of years 1 through 7. Year 1 sales of hog feed are expected to be $4.30 million, and thereafter, sales are forecasted to grow by 5% a year, slightly faster than the inflation rate. Manufacturing costs are expected to be 90% of sales, and profits are subject to tax at 21%. The cost of capital is 12%.
What is the NPV of Pigpen’s project? (Enter your answer in thousands, not in millions, rounded to the nearest dollar.)
NPV $__________________ thousand ???
1) What is the Net Present Value of Pigpen's project?
To find the Net Present Value (NPV) of the project, the free cash flow from the project should be computed. The following table shows the cash flow.
| $ in '000 | Year 0 | Year 1 | Year 2 | Year 3 | Year 4 | Year 5 | Year 6 | Year 7 | Year 8 |
| Sale of hog feed | $ - | $ 4,300 | $ 4,515 | $ 4,741 | $ 4,978 | $ 5,227 | $ 5,488 | $ 5,762 | $ 6,051 |
| Less: Manufacturing costs @90% | $ - | $ 3,870 | $ 4,064 | $ 4,267 | $ 4,480 | $ 4,704 | $ 4,939 | $ 5,186 | $ 5,445 |
| Net Contribution from the project | $ - | $ 430 | $ 452 | $ 474 | $ 498 | $ 523 | $ 549 | $ 576 | $ 605 |
| Less: Warehouse rental (opportunity cost) | $ - | $ 105 | $ 109 | $ 114 | $ 118 | $ 123 | $ 128 | $ 133 | $ 138 |
| Less: Depreciation | $ - | $ 123 | $ 123 | $ 123 | $ 123 | $ 123 | $ 123 | $ 123 | $ 123 |
| Earnings Before Tax | $ - | $ 202 | $ 219 | $ 238 | $ 257 | $ 277 | $ 298 | $ 320 | $ 344 |
| Less: Tax @ 21% | $ - | $ 42 | $ 46 | $ 50 | $ 54 | $ 58 | $ 63 | $ 67 | $ 72 |
| Net Income | $ - | $ 160 | $ 173 | $ 188 | $ 203 | $ 219 | $ 235 | $ 253 | $ 272 |
| Add: Depreciation | $ - | $ 123 | $ 123 | $ 123 | $ 123 | $ 123 | $ 123 | $ 123 | $ 123 |
| Operating Cash Flow - A | $ - | $ 283 | $ 296 | $ 311 | $ 326 | $ 342 | $ 358 | $ 376 | $ 395 |
| Purchase of Plant & Machinery - B | $ (1,230) | $ - | $ - | $ - | $ - | $ - | $ - | $ - | $ - |
| Working Capital - Opening | $ - | $ 355 | $ 430 | $ 452 | $ 474 | $ 498 | $ 523 | $ 549 | $ 576 |
| Working Capital - Closing | $ 355 | $ 430 | $ 452 | $ 474 | $ 498 | $ 523 | $ 549 | $ 576 | $ - |
| Net Working Capital (Opening - Closing) - C | $ (355) | $ (75) | $ (22) | $ (23) | $ (24) | $ (25) | $ (26) | $ (27) | $ 576 |
| Sale of Plant & Machinery - D | $ - | $ - | $ - | $ - | $ - | $ - | $ - | $ - | $ 376 |
| Free Cash Flow - A+B+C+D | $ (1,585) | $ 208 | $ 275 | $ 288 | $ 302 | $ 317 | $ 332 | $ 349 | $ 1,346 |
Note 1: Depreciation
Depreciation = (Cost of Asset - Salvage value) ÷ Life of Asset
Depreciation =1,230÷ 10 (Salvage value is NIL).
Depreciation = $ 123.
Note 2: Net Working Capital
Closing Working capital will be 10% of the sales and the Net working capital to be considered for the cash flow will be Opening less closing working capital. Opening for Year 0 and closing for Year 8 will be Nil.
Note 3: Rental charge paid to ware house to be utilised for the current project is an opportunity cost and hence considered for this project as a cash outflow.
Note 4: Sale of Plant & Machinery.
| Sale value of the asset - A | $ 410 | |
| Book value of the Asset (Cost - Depreciation for 8 years) | $ 246 | |
| Profit on sale of Asset | $ 164 | |
| Tax on profit @ 21% - B | $ 34 | |
| Net Cash from sales C = A - B | $ 376 |
Net Present Value (NPV) -
NPV should be found out by discounting the free cash flow with the appropriate discounting factor (in this case it is 12%). The following table shows the NPV for this project.
| Year | Cash Flow - A | Discounting Factor @ 12% - B | Present Value - A x B |
| Year 0 | $ (1,585) | 1.000 | $ (1,585) |
| Year 1 | $ 208 | 0.893 | $ 185 |
| Year 2 | $ 275 | 0.797 | $ 219 |
| Year 3 | $ 288 | 0.712 | $ 205 |
| Year 4 | $ 302 | 0.636 | $ 192 |
| Year 5 | $ 317 | 0.567 | $ 180 |
| Year 6 | $ 332 | 0.507 | $ 168 |
| Year 7 | $ 349 | 0.452 | $ 158 |
| Year 8 | $ 1,346 | 0.404 | $ 544 |
| NPV (Sum) | $ 266 |
| Discounting factor = 1/(1+i)^n | |||
| i = Discounting rate (in this case 12%) | |||
| n = Period (in this case 1 to 8). |
NPV of the project is $266 thousand
