Question

Kdua Products is considering a new project that requires an investment of $24 million in machinery. This is expected to produce sales of $65 million per year for 3 years. Operating expenses are 70% of sales. The machinery will be fully depreciated to a zero book value over 3 years using straight-line depreciation. There is no salvage value. There is an initial investment of $3 million in net working capital. At the end of year 3, the firm gets $2 million back in net working capital. The tax rate is 40%. You estimate that Whoopee will have a residual value of $12 million at the end of the 3 years. The unlevered return on assets is 11%.
a) Calculate the base-case NPV (net present value).
b) Kdua plans to use $8,000,000 in debt at 6% to fund the project. Use Adjusted Present Value (APV) to find the value of the project. The debt has a three-year life.

Answer 1

Answer on Question #42113, Economics, Finance

a) Firstly, we should calculate cash flow per year.

$$CF0 = -24 - 3 = -\$27 \text{ million}$$ $$CF1 = 65 \times (1 - 0.7) \times (1 - 0.4) = \$11.7 \text{ million}$$ $$CF2 = 65 \times (1 - 0.7) \times (1 - 0.4) = \$11.7 \text{ million}$$ $$CF3 = 65 \times (1 - 0.7) \times (1 - 0.4) + 3 + 12 = \$26.7 \text{ million}$$$$NPV = -27 + 11.7 / 1.11 + 11.7 / 1.11^2 + 26.7 / 1.11^3 = \$12.56 \text{ million}$$ $$APV = \text{Unlevered NPV of Free Cash Flows and assumed Terminal Value} + \text{NPV of Interest Tax Shield and assumed Terminal Value}$$

The discount rate used in the first part is the return on assets or return on equity if unlevered. The discount rate used in the second part is the cost of debt financing by period.

EBIT - Taxes on EBIT = Net Operating Profit After Tax (NOPAT) + Non cash items in EBIT - Working Capital changes - Capital Expenditures and Other Operating Investments = Free Cash Flows