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Homework answers / question archive / JCC Network (JCC) is a fast-growing Internet service provider that initially went public in 2010
JCC Network (JCC) is a fast-growing Internet service provider that initially went public in 2010. Its revenue growth and profitability have steadily risen since the company's inception in early 2000. JCC is considering a new project of extending its services to rural area. If the company carries out the project, it needs to purchase a new machine that costs $720,000. For tax purposes, the machine will be fully depreciated by the simplified straight-line method over a period of three years. It is estimated that the machine will be able to generate $580,000 in incremental sales and the annual cash expenses of the company will increase by $150,000. Besides, the company will need $180,000 in initial net working capital for the project. As the new machine requires more space, the company will make use of a warehouse, which is currently rented out for $60,000 per year. In addition, the average tax rate, the marginal tax rate, and the required rate of return for the company are 20%, 30% and 10% respectively. As a finance manager of the company, you are required to evaluate this project. Required: a. Discuss whether or not the following items are relevant cash flows for the project and should be included in the capital budgeting. i. the rental income of the warehouse (6 marks) ii. the initial net working capital of the project (6 marks) iii. the annual depreciation of the machine (8 marks) b. Determine the annual after-tax cash flows associated with this project for years O through 3. You need to show your steps clearly in order to get full marks. (20 marks) c. Perform a capital budgeting analysis to determine whether the company should accept the project. You need to show your steps clearly in order to get full marks.
ANSWER -
a.
i. Rental Income of Warehouse: It is a relevant cashflow for this project because if this project is not undertaken by the company, then it would get $60,000 as rent per year which will not be there in case of project. Thus, it would be treated as similar to a cash outflow as not getting cash inflow is like cash outflow only.
ii. Initial Net Working Capital will also be a relevant cashflow as the company needs to invest in this at the begining of the project and get this cashflow after the project is wound up. Thus, present value of both the cashflows would be different. Therefore, it is a relevant cashflow for this project.
iii. Annual depreciation would also be a relevant cashflow for this project as this deprecaition can save potential cash outflows in form of taxes. Since depreciation is a tax deductible expense, it can save taxes for the company which are relevant for this project.
b.
Cashflows for Year 0:
Initial Investment in Machinery = $720,000
Increase in Net Working Capital = $180,000
Total CashOutflow for Year 0 = Initial Investment in Machinery + Increase in Net Working Capital
Total CashOutflow for Year 0 = 720,000 + 180,000 = $900,000
Cashflows in Year 1 to 3:
Incremental Revenues of the Project = $580,000
Incremental Cash Expenses of the Project = $150,000
Incremental Depreciation of Project = 
Incremental Depreciation of Project = 
= $240,000
Lost Profits due to Warehouse Rent = $60,000
Incremental Profit for Project = 580,000 - 150,000 - 240,000 - 60,000 = 130,000
Incremental Taxes for Project = Incremental Profits * Marginal Tax Rate
Incremental Taxes for Project = 130,000 * 30% = 39,000
After Tax Cashflow for the Project = Incremental Profit - Incremental Taxes + Depreciation
After Tax Cashflow for the Project = 130,000 - 39,000 + 240,000 = $331,000
Terminal Year Cashflow i.e. Year 3 Additional Cashflow:
Cashflow from release of Net Working Capital = $180,000
c.
Required Rate of Return (Discount Rate) = 10%
NPV of Project = Present Value of CashInflows - Cash Outflow
NPV = 331,000 / (1 + 10%)1 + 331,000 / (1 + 10%)2 + (331,000 + 180,000) / (1 + 10%)3 - 900,000
NPV = $58,385
Since NPV of this project is +ve, company should accept the project as it will increase the value of firm.
