Question

Better mousetraps has developed a new trap. it can go into production for an initial investment in equipment of $6.3 million. the equipment will be depreciated straight-line over 6 years, but, in fact, it can be sold after 6 years for $695,000. the firm believes that working capital at each date must be maintained at a level of 10% of next year’s forecast sales. the firm estimates production costs equal to $1.80 per trap and believes that the traps can be sold for $7 each. sales forecasts are given in the following table. the project will come to an end in 6 years, when the trap becomes technologically obsolete. the firm’s tax bracket is 40%, and the required rate of return on the project is 11%. year: 0 1 2 3 4 5 6 thereafter sales (millions of traps) 0 0.6 0.8 0.9 0.9 0.5 0.2 0 suppose the firm can cut its requirements for working capital in half by using better inventory control systems. by how much will this increase project npv? note: do not round your intermediate calculations. enter your answer in millions rounded to 4 decimal places.

Answer 1

To increase the project NPV, the firm is considering reducing its working capital requirements by half through better inventory control. This will free up cash, increase free cash flow, and in turn positively impact the NPV when calculated using the discounted cash flow method, accounting for the project's 6-year lifespan and the 11% required rate of return.

Step-by-step explanation:

The question asks about the increase in the project NPV (Net Present Value) if the firm can reduce its working capital requirements by implementing better inventory control systems. Currently, working capital is maintained at a level of 10% of next year's forecast sales, which necessitates cash to be tied up in inventory, receivables, and other short-term assets needed for operations. By reducing these requirements by half, the firm would effectively liberate funds that would otherwise be locked in working capital, increasing the free cash flow available to the firm and, subsequently, the NPV of the project.

An accurate calculation of the increase in NPV would require an analysis of the forecast sales figures, effective working capital reductions for each year, and the application of the required rate of return of 11%. This would entail applying the discounted cash flow method to the incremental free cash flows resulting from the reduced working capital requirements, taking into account the tax implications and the time value of money for the entire project lifespan of 6 years.