Question

Revenues generated by a new fad product are forecast as follows: yr1 $60,000, yr2 $40,000, yr3 $30,000, yr4 $20,000, thereafter 0. expenses are expected to be 40% of revenues and working capital required in each year is expected to be 30% of revenues in the following year. the product requires a immediate investment of $70,000 in plant and equipment. required: a. what is the initial investment in the product? remember working capital. b. if the plant and equipment are depreciated over 4 years to a salvage value of zero using straight-line depreciation, and the firm's tax rate is 20%, what are the project cash flows in each year? c. if the opportunity cost of capital is 10%, what is project npv? d. what is project irr?

Answer 1

a. The initial investment in the product is $88,000, which includes both the plant and equipment investment and the working capital. b. The project cash flows in each year can be calculated by subtracting expenses from revenues and considering depreciation. c. The project NPV can be calculated by discounting the project cash flows using the opportunity cost of capital. d. The project IRR is the discount rate at which the NPV of the project becomes zero.

Step-by-step explanation:

a. The initial investment in the product includes the plant and equipment investment and the working capital. The plant and equipment investment is $70,000. The working capital required in each year is 30% of the revenues in the following year. So, the working capital in Year 1 is 30% of $60,000, which is $18,000. Hence, the initial investment is $70,000 + $18,000 = $88,000.

b. To calculate the project cash flows in each year, we need to subtract the expenses from the revenues and consider depreciation. The expenses are expected to be 40% of revenues. So, the expenses in Year 1 are 40% of $60,000, which is $24,000. The depreciation expense for the plant and equipment is $70,000 divided by 4 years, which is $17,500 per year. The project cash flow in Year 1 is $60,000 - $24,000 - $17,500 = $18,500. Similarly, you can calculate the cash flows for the other years.

c. To calculate the project NPV, we need to discount the project cash flows using the opportunity cost of capital, which is 10%. The NPV formula is: NPV = CF1 / (1 + r) + CF2 / (1 + r)^2 + ... + CFn / (1 + r)^n, where CF is the cash flow and r is the discount rate. You can calculate the NPV by applying this formula to the project cash flows in each year.

d. The project IRR is the discount rate at which the NPV of the project becomes zero. You can find the project IRR by applying trial and error or by using a financial calculator or spreadsheet software.