A project requires an initial investment in equipment of $90,000 and then requires an initial investment in working capital of $10,000 (at t = 0).You expect the project to produce sales revenue of $120,000 per year for three years.You estimate manufacturing costs at 60 percent of revenues.(Assume all revenues and costs occur at year-end [i.e., t = 1, t = 2, and t = 3]).The equipment depreciates using straight-line depreciation over three years.At the end of the project, the firm can sell the equipment for $10,000 and also recover the investment in net working capital.The corporate tax rate is 30 percent and the cost of capital is 15 percent.Cash flows from the project are A)CF₀: -90,000; CF₁: 12,600; CF₂: 12,600; CF₃: 29,600. B)CF₀: -100,000; CF₁: 42,600; CF₂: 42,600; CF₃: 59,600. C)CF₀: -100,000; CF₁: 42,600; CF₂: 42,600; CF₃: 42,600. D)CF₀: -100,000; CF₁: 42,600; CF₂: 42,600; CF₃: 49,600.

Question

Quizplus · Accepted Answer

Year 0:
Initial investment = -$100,000 (equipment cost of $90,000 + working capital of $10,000)

Year 1, 2, 3:
Sales revenue = $120,000
Manufacturing costs = 60% of revenue = $72,000
EBITDA = $48,000
Depreciation = $30,000 (straight-line depreciation over 3 years)
EBIT = $18,000
Taxes = 30% of EBIT = $5,400
Net income = $12,600

Year 3:
Sale of equipment = $10,000
Recovery of working capital = $10,000
Tax on sale of equipment = $1,200 (30% of $4,000 gain)
Net cash flow from the sale = $12,800

Total cash flows:
Year 0 = -$100,000
Year 1 = $12,600
Year 2 = $12,600
Year 3 = $12,800

Using a cost of capital of 15%, we can calculate the present value of each cash flow:

PV of Year 0 = -$100,000
PV of Year 1 = $10,956
PV of Year 2 = $9,516
PV of Year 3 = $8,451

Summing the present values, we get a net present value (NPV) of $-71,077. This is negative, so the project should not be undertaken.

Therefore, the best choice is B.

A Project Requires an Initial Investment in Equipment of $90,000