NPV Calculation for an Investment Opportunity, Lecture notes of Accounting

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FINC 430 TA Review Session 5

Capital Budgeting and Pro Formas

Solutions

Marco Sammon

Question 1 (7-6 in the Textbook)

FastTrack Bikes, Inc. is thinking of developing a new

composite road bike. Development will take six years and

the cost is $200,000 per year. Once in production, the

bike is expected to make $300,000 per year for 10 years.

Assume the cost of capital is 10%.

(a) Calculate the NPV of this investment opportunity,

assuming all cash flows occur at the end of each year.

Should the company make the investment?

(b) By how much must the cost of capital estimate deviate

to change the decision? (Hint: Use Excel to calculate the

IRR.)

(c) What is the NPV of the investment if the cost of capital

is 14%?

The NPV is the difference between the present value of two cash flows- an annuity of $300,000 from years 7-16 and another annuity of $200,000 from years 1- ଺ ଺ ଵ଴ ଺ ଺ ଵ଴ NPV > 0, so the company should take the project.

Variation of Method 1, but using the PV function in Excel instead of the growing annuity formula The NPV is the difference between the present value of two cash flows- an annuity of $300,000 from years 7- and another annuity of $200,000 from years 1-. ల

Alternatively, set up the cash flows in Excel. Then use the NPV

function (not the PV function). I give the screenshot below.

Notice carefully the inputs to the NPV function. The first is the

discount rate (input either as “0.1” or “10%”). The second is the

sequence of cash flows.

NPV = $169,

(b) By how much must the cost of capital

estimate deviate to change the decision? (Hint:

Use Excel to calculate the IRR.)

Setting the NPV = 0 and solving for r (using a

spreadsheet) the answer is IRR = 12.66%.

So if the estimate is too low by 2.66%, the

decision will change from accept to reject.

Question 2 (8- 7 in the Textbook)

Castle View Games would like to invest in a division to develop

software for video games. To evaluate this decision, the firm first

attempts to project the working capital needs for this operation.

Its chief financial officer has developed the following estimates

(in millions of dollars):

Assuming that Castle View currently does not have any working

capital invested in this division, calculate the cash flows

associated with changes in working capital for the first five years

of this investment. (End of question)

Year 1 Year 2 Year 3 Year 4 Year 5

Cash 6 12 15 15 15

Accounts receivable 21 22 24 24 24

Inventory 5 7 10 12 13

Accounts payable 18 22 24 25 30

(a)

(b)

Question 4 (8- 10 in the Textbook)

You are a manager at Percolated Fiber, which is considering expanding its

operations in synthetic fiber manufacturing. Your boss comes into your office,

drops a consultant’s report on your desk, and complains, “We owe these

consultants $1 million for this report, and I am not sure their analysis makes

sense. Before we spend the $25 million on new equipment needed for this

project, look it over and give me your opinion.” You open the report and find the

following estimates (in thousands of dollars):

Project Year 1 2 … 9 10 Sales revenue 30,000 30,000 30,000 30,

• Cost of goods sold 18,000 18,000 18,000 18, = Gross profit 12,000 12,000 12,000 12,
• General, sales, and administrative expenses 2,000 2,000 2,000 2,
• Depreciation 2,500 2,500 2,500 2, = Net operating income 7,500 7,500 7,500 7,
• Income tax 2,625 2,625 2,625 2, = Net income 4,875 4,875 4,875 4,

(a) Free Cash Flows are: (b) ଵ ଴.ଵସ ଵ ଵ.ଵସవ ଵ଼ .଴ଶହ ଵ.ଵ.ସభబ 0 1 2 … 9 10 = Net income 4,875 4,875 4,875 4,

• Overhead (after tax at 35%) 650 650 650 650
• Depreciation 2,500 2,500 2,500 2,

• Capex 25,
• Inc. in NWC 10,000 – FCF –35,000 8,025 8,025 … 8,025 18,

Question 5

You are the CFO of a manufacturing company and your job is to value a potential new project. The project details are as follows:

• Revenue is forecast to be $350 million at t=1 and will grow year at a rate of 12% from t=1 to t=2 then 10% from t=2 to t=3, then 5% from t=3 to t=4, then level off at a rate of 4% thereafter.
• Total operating expenses (OPEXP), COGS and SG&A, are forecast to be 40% of revenue.
• Starting at t=0, inventories will be 75% of the following year’s OPEXP.
• The firm pays for 60% of the inventories when they are purchased and 40% the year after.
• There are no accounts receivable.
• The project will have a life-span of five years after which it will be stopped.
• For the project to start they need money for capital expenditures (CAPEX) today, at t=0, of $150 million.
• This CAPEX will be scraped for zero value at the end of the life of the project.
• CAPEX is depreciated across two years.
• The firm’s tax rate is 20%. (a) What are the free cash flows for years t=1 to 5? (b) What is the IRR of the project? (c) If the discount rate is 15%, what is the NPV of the project? Should your firm invest in the new project? (End of question)

Long-Term and Short-Term Investments

• Year 0 Year 1 Year 2 Year 3 Year 4 Year
• 1 Cash
• 2 Accounts receivable^21 22 24 24
• 3 Inventory
• 4 Accounts payable
• 5 Net Working Capital (1+2+3-4)^0 14 19 25 26
• 6 Increase in NWC 14 5 6 1 -
• CAPEX $
• DEPR $75 $
• INV $105 $118 $129 $136 $141 $
• AR $0 $0 $0 $0 $0 $
• AP $42.00 $47.04 $51.74 $54.33 $56.50 $0.
• NWC $63 $71 $78 $81 $85 $
• Change in NWC $63 $8 $7 $4 $3 -$