Question

You are provided with the projected income statements for a project: Year 1 2 3 4 Revenues ( MUR '000) 10,000 11,000 12,000 13,000 Less Cost of Goods Sold ( MUR '000) 4,000 4,400 4,800 5,200 Less Depreciation ( MUR '000) 4,000 3,000 2,000 1,000 Earnings Before Interest and Tax ( MUR '000) 2,000 3,600 5,200 6,800 The tax rate is 40%. The project requires an initial investment of MUR 15 million and an additional MUR 2 million at the end of year 2. The working capital is anticipated to be 10% of revenues and the working capital investment has to be made at the beginning of each period. Estimate the free cash to the firm for each of the 4 years, the payback period for investors in the firm, and the net present value if the cost of capital is 12 %? Would you accept the project?

Answer 1

a. Free cash to the firm:

Year 1 2 3 4

Free Cash Flow to the firm ( MUR '000) 3,708 3,542 3,506 3,470

b. The payback period for this project, based on the free cash flow, is after year 4.

c. The net present value is (MUR 5,757,000)

d. No. Based on the payback period and the net present value, the project should be rejected.

Step-by-step explanation:

a) Data and Calculations:

Projected Income Statements

Year 1 2 3 4

Revenues ( MUR '000) 10,000 11,000 12,000 13,000

Less Cost of Goods Sold ( MUR '000) 4,000 4,400 4,800 5,200

Less Depreciation ( MUR '000) 4,000 3,000 2,000 1,000 Earnings b/4 Interest & Tax ( MUR '000) 2,000 3,600 5,200 6,800

Interest on capital (12%) ( MUR '000) 1,800 2,040 2,040 2,040

Earnings before tax ( MUR '000) 200 1,560 3,160 4,760

Income Tax (40%) 80 624 1,264 1,904

Net Income after tax ( MUR '000) 120 936 1,896 2,856

Add Depreciation ( MUR '000) 4,000 3,000 2,000 1,000

Net cash from operations (MUR '000) 4,120 3,936 3,896 3,856

Working capital investment (MUR '000) 412 394 390 386

Free Cash Flow to the firm 3,708 3,542 3,506 3,470 Net present value

The payback period for this project, based on the free cash flow, is after year 4.

Interest on capital:

Initial investment = MUR 15 million * 12% = MUR 1,800,000 for year 1

Additional investment = MUR 2 million * 12$ = 240,000

Total interest expense from year 2 = MUR 2,040,000

Net present value:

Year 1 2 3 4 Total

Free Cash Flow to the firm 3,708 3,542 3,506 3,470 14,226

Discount factor 0.893 0.797 0.712 0.636

Present value 3,311 2,823 2,496 2,207 10,837

Cash outflows: 15,000 1,594 0 0 16,594

Net present value = (5,757)

Cash outflow for year 2 = 2,000,000 * 0.797 = 1,594,000