John Kay Inc.is considering the installation of a new production line to make automated flying shuttles for weaving machines.The capital cost of the equipment is $2.2 million.The machines on the new line are classified as 15-year property.Kay plans to operate the line for 2 years,at which time the project will end and the assets will be disposed of for $1,000,000.The new line requires an increase in net working capital of $20,000,which would be liquidated at the end of the project.The investment outlays would occur immediately.
Sales are expected to be constant at $2,000,000,and operating expenses at $800,000.Assume that all revenues and operating expenses are received (paid)at the end of each of the two years of operations.Kay's marginal tax rate is 35 percent.Kay's cost of capital is 11%.What is the NPV for the proposed acquisition if the cost of capital is 11%?
MACRS Depreciation Rates

Question

Quizplus · Accepted Answer

Step 1 - Compute the initial cash flow.
Initial Cash Flow = - (Initial purchase price of new asset) - (Increase in Net Working Capital)
Initial cash flows = - 2,200,000 - 20,000 = -$2,220,000
Step 2 - Compute the operating cash flow.
EBIT = Revenues - Expenses - Depr
Revenues = 2,000,000
Expenses = 800,000
Depr = 0.05 × 2,200,000 = $110,000
EBIT = 2,000,000 - 800,000 - 110,000 = $1,090,000
NOPAT = EBIT × (1 - T)
NOPAT = 1,090,000 × (1 - 0.35) = $708,500
OCF = NOPAT + Depreciation
OCF = 708,500 + 110,000 = $818,500
 11ea7fdb_fc86_5a41_a768_c56ee12e395b_TB2902_00 Step 3 - Compute the terminal year cash flow.
 11ea7fdb_fc86_5a42_a768_c7d5714074cb_TB2902_00 EBIT = Revenues - Expenses - Depr
Revenues = $2,000,000
Expenses = $800,000
Depr = 0.095 × 2,200,000 = $209,000
EBIT = 2,000,000 - 800,000 - 209,000 = $991,000
NOPAT = EBIT × (1 - T)
NOPAT = 991,000 × (1 - 0.35) = $644,150
OCF = NOPAT + Depreciation
OCF = 644,150 + 209,000 = $853,150
Net Salvage = Salvage - T × (Salvage - Book Value)
Net Salvage = $1,000,000 - ($1,000,000 - $1,881,000) × 0.35 = $1,308,350
Terminal Cash Flows = OCF + (Decrease in net working capital) + (Net salvage plant)
Terminal Cash Flows = 853,150 + 20,000 + 1,308,350 = $2,181,500
Step 4 - Compute the NPV
NPV = -$2,220,000 - $818,500/(1.11) + $2,181,500/ 11ea7fdb_fc86_8153_a768_7148a1a93dd7_TB2902_11 NPV = $287,942