United Pigpen is considering a proposal to manufacture high-protein hog feed

Finance Dec 22, 2020

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 ???

Expert Solution

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

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