Question

Esfandairi Enterprises is considering a new three-year expansion project that requires an initial fixed asset investment of $2.18 million. The fixed asset will be depreciated straightline to zero over its three-year tax life, after which time it will be worthless. The project is estimated to generate $1.645 million in annual sales, with costs of $610,000. The project requires an initial investment in net working capital of $250,000, and the fixed asset will have a market value of $180,000 at the end of the project. The tax rate is 21 percent.

a. What is the project's Year 0 net cash flow? Year 1? Year 2? Year 3?
b. If the required return is 12 percent, what is the project's NPV?

Answer 1

The project's net cash flows for each year are -$2.43 million, $1.405 million, $1.405 million, and $1.405 million. The project's NPV, using a required return of 12 percent, is $2.16 million.

Step-by-step explanation:

The net cash flow for each year of the project can be calculated as follows:

1. Year 0: The net cash flow in Year 0 includes the initial fixed asset investment and the initial investment in net working capital. Therefore, the net cash flow in Year 0 is -$2.18 million (fixed asset investment) - $250,000 (initial net working capital investment) = -$2.43 million.
2. Year 1: The net cash flow in Year 1 includes the annual sales revenue, costs, and depreciation of the fixed asset. Therefore, the net cash flow in Year 1 is $1.645 million (sales revenue) - $610,000 (costs) - ($2.18 million / 3 years) = $1.405 million.
3. Year 2: The net cash flow in Year 2 is calculated in the same way as Year 1, so it is also $1.405 million.
4. Year 3: The net cash flow in Year 3 is calculated in the same way as Year 1 and Year 2, so it is also $1.405 million.

To calculate the project's NPV, we need to discount the net cash flows to present value using the required return of 12 percent. The NPV formula is:

NPV = Year 0 net cash flow + (Year 1 net cash flow / 1.12) + (Year 2 net cash flow / 1.12^2) + (Year 3 net cash flow / 1.12^3)

Substituting the values into the formula, we get:

NPV = -$2.43 million + ($1.405 million / 1.12) + ($1.405 million / 1.12^2) + ($1.405 million / 1.12^3)

Solving this equation gives the project's NPV as $2.16 million.

Answer 2

The project's Year 0 net cash flow is $1.93 million, Year 1 is $717,833.33, Year 2 is $717,833.33, and Year 3 is $1,497,833.33. The project's NPV, using a required return rate of 12%, is $1,647,811.59.

Step-by-step explanation:

The net cash flow for a project in Year 0 is the initial fixed asset investment minus the initial investment in net working capital. Therefore, the Year 0 net cash flow for this project is $2.18 million minus $250,000, which equals $1.93 million.

The net cash flow for Year 1 is the annual sales minus the costs, minus the depreciation expense for that year, plus the change in net working capital. Therefore, the Year 1 net cash flow for this project is $1.645 million minus $610,000, minus ($2.18 million divided by 3), plus ($250,000 minus ($2.18 million divided by 3)), which equals $717,833.33.

The net cash flow for Year 2 is calculated in the same way as Year 1. Therefore, the Year 2 net cash flow for this project is $1.645 million minus $610,000, minus ($2.18 million divided by 3), plus ($250,000 minus ($2.18 million divided by 3)), which equals $717,833.33.

The net cash flow for Year 3 is calculated in the same way as Year 1 and Year 2, with the exception that the fixed asset has a market value of $180,000 at the end of Year 3. Therefore, the Year 3 net cash flow for this project is $1.645 million minus $610,000, minus ($2.18 million divided by 3), plus ($250,000 minus ($2.18 million divided by 3)), plus ($180,000), which equals $1,497,833.33.

The project's NPV can be calculated by discounting the net cash flows at the required return rate (12%). The NPV is the sum of the present values of the net cash flows. Therefore, the NPV for this project is the present value of Year 0 net cash flow, plus the present value of Year 1 net cash flow, plus the present value of Year 2 net cash flow, plus the present value of Year 3 net cash flow. Using a financial calculator or spreadsheet, the NPV is $1,647,811.59.