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Posted on May 1st, 2014, by

Assignment.

Using the information in the assignment description:

1. Prepare a statement showing the incremental cash flows for this project over an 8-year period.

2. Calculate the payback period (P/B) and the net present value (NPV) for the project.

3. Answer the following questions based on your P/B and NPV calculations:

3a. Do you think the project should be accepted? Why?

3b. Assume the company has a P/B (payback) policy of not accepting projects with life of over 3 years.

3c. If the project required additional investment in land and building, how would this affect your decision? Explain.

Solution.

1.

In order to prepare the statement of incremental cash flows, it is necessary to determine for every year: investments (cash flows should be reduced by the value of investments), revenues less direct costs, indirect costs and depreciation which equals to EBT, earnings before taxes (Ross, Westerfield & Jordan, 2004), tax value calculated basing on EBT, tax-deduced earnings, which are referred to as EAT, earnings after taxes (Ross, Westerfield & Jordan, 2004). In order to determine annual cash flows, depreciation should be added back to the EAT values (Ross, Westerfield & Jordan, 2004).

Using the assignment data projected revenue values, investments, direct and indirect costs, straight depreciation, and additional investment value, Table 1 for calculating annual cash flows was created in Excel.

Year

0

1

2-5 6-8
Investments

($1,700,000)

Revenue

$950,000

$1,500,000

$1,500,000

less Direct costs

($427,500)

($675,000)

($675,000)

less Indirect costs

($95,000)

($95,000)

($95,000)

less Depreciation

($300,000)

($300,000)

$0

EBT contribution

$127,500

$430,000

$730,000

less Tax

($44,625)

($150,500)

($255,500)

EAT contribution

$82,875

$279,500

$474,500

add back depreciation

$300,000

$300,000

$0

NCF

($1,700,000)

$382,875

$579,500

$474,500

Table 1. NCF calculation

Here investments equal to the overall value of investment ($1,500,000 + $200,000); direct costs were calculated as 45% of revenues, indirect costs were equal to $95.000 for every year, and marginal tax rate was set to 35% (tax equals to 35% of EBT). EAT equals EBT less tax value, and NCF equals to EAT plus investments plus depreciation. Depreciation value was calculated as plant cost ($1,500,000) divided by 5 years, and equals to $300,000 annually. Additional investments in inventory and receivable were not depreciated.

Using NCF values, it is possible to determine incremental cash flows for every year, and cumulative cash flows. Table 2 shows the values of these cash flows:

Year NCF Cumulative CF

0

($1,700,000)

($1,700,000)

1

$382,875

($1,317,125)

2

$579,500

($737,625)

3

$579,500

($158,125)

4

$579,500

$421,375

5

$579,500

$1,000,875

6

$474,500

$1,475,375

7

$474,500

$1,949,875

8

$474,500

$2,424,375

Table 2. NCF and cumulative cash flows for 8 years

2.

It is necessary to calculate payback period and net present value (NPV) of the project. Payback period is the duration of period of time needed to recover the costs of the investment (Lasher, 2010). In other words, it is the time needed for cumulative cash flows to become positive (above 0).

Net present value is the difference between the present values of cash inflows and outflows, i.e. the sum of present values of annual cash flows. It is one of the most popular features used to measure financial viability of projects, and is calculated using the following formula: , where n is the number of years for the project, r is the cost of capital for the company, and CFi denotes cash flow for year i (Lasher, 2010). Table 3 shows the calculations of NPV (along with supplementary values of (1+r)i) and payback period.

Year NCF Cumulative CF Payback period (1+r)^i PV(NCF)

0

($1,700,000)

($1,700,000)

1.00

($1,700,000)

1

$382,875

($1,317,125)

1.10

$348,068

2

$579,500

($737,625)

1.21

$478,926

3

$579,500

($158,125)

1.33

$435,387

4

$579,500

$421,375

3.27

1.46

$395,806

5

$579,500

$1,000,875

1.61

$359,824

6

$474,500

$1,475,375

1.77

$267,843

7

$474,500

$1,949,875

1.95

$243,494

8

$474,500

$2,424,375

2.14

$221,358

NPV

$1,050,705

Table 3. NPV and payback for the project

Payback period is 3.27 years. Fractional part of payback period calculated as total NCF for year 5 divided by the absolute value of negative cash flow in this year. Present values of cash flows were calculated by dividing NCF for each year by (1+r)i. NPV = $1,050,207.

3.

3a. Payback period is 3.27 years, which means that in the second quarter of year 4 the costs of the investment will be recovered. Thus, the project is profitable and should be accepted.

NPV = $1,050,207, which is greater than zero, and since NPV is positive, the project is financially viable, and should be accepted.

3b. If the company would have a policy of not accepting projects with life over 3 years, this project would not be accepted, because its payback period is longer than 3 years (3.27) and this would not comply with the policy.

3c. If the project would require additional investment in land and building, it would need additional consideration (and recalculation of NPV and payback period). In this case, depending on the volume of investments, the project could be either financially viable or not. It is not possible to state whether the project would be profitable with additional investment in land and building without knowing the exact figures. There is a possibility that it would become not profitable.

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