Take-home Exercise 2

Your company has been doing well, reaching $1.5 million in earnings, and is considering launchi
ng a new product. Designing the new product has already cost $500,000. The company estimates
that it will sell 820,000 units per year for $3.5 per unit and variable non-labor costs will be $1 pe
r unit. Production will end after year 3. New equipment costing $1 million will be required. The
equipment will be put into use in year 1 and depreciated to zero using the 7-year MACRS schedu
le. You plan to sell the equipment for book value at the end of year 3. Your current level of work
ing capital is $335,000. The new product will require the working capital to increase to a level of
$400,000 immediately, then to $470,000 in year 1, in year 2 the level will be $515,000, and finall
y, in year 3 the level will return to $335,000. Your tax rate is 21%. The discount rate for this proj
ect is 10%. Do the capital budgeting analysis for this project and calculate its NPV. 
 Solution

Current Year 0 Year 1 Year 2 Year 3

Sale $ 2,870,000 $ 2,870,000 $ 2,870,000
(820,000*$3.5)
Costs $ 1,230,000 $ 1,230,000 $ 1,230,000
(820,000*$1.5)
Depreciation $ 142,900 $ 244,900 $ 174,900
($1,000,000*7-year
MACRS)

EBT $ 1,497,100 $ 1,395,100 $ 1,465,100

(Sale – Costs –
Depreciation)

Tax $ 314,391 $ 292,971 $ 307,671

(EBT*21%)

Net Income $ 1,182,709 $ 1,102,129 $ 1,157,429

(EBT – Taxes)

OCF $ 1,325,609 $ 1,347,029 $ 1,332,329

(NI+Depreciation)

Capital spending $ (1,000,000) $ 437,300

(Machine)

NWC $ 335,000 $ 470,000 $ 515,000 $ 350,000 $ 335,000

Change in NWC $ (135,000) $ (45,000) $ 165,000 $ 15,000

Incremental cash $ (1,135,000 ) $ 1,280,609 $ 1,512,029 $ 1,784,629

flow
(OCF+Capital
speding+Chang in
NWC)

1,280,609 1,512,029 1,784,629

____________
NPV = (-1,135,000 ) + + _______________ + ____________
2
(1 + .1) (1 + .1) (1 + .1) 3
 = $2,619,619

Calculations:
● Sales Revenue = Number of units per year * Price per unit
= 820,000 * $3.5 = $2,870,000

● Costs = Number of units per year * Variable non-labor costs

= 820,000 * $1.5 = 1,230,000

● Depreciation rates of the first 3 years using the 7-year MACRS schedule:

● Depreciation = Cost of FA * MACRS rate

→ Year 1 Dep = $1,000,000 * 0.1429 = $142,900
→ Year 2 Dep = $1,000,000 * 0.2449 = $244,900
→ Year 3 Dep = $1,000,000 * 0.1749 = $174,900

● EBIT = Sales revenue - Costs - Depreciation

→ Year 1 = $2,870,000 - $820,000 - $142,900 = $1,497,100
→ Year 2 = $2,870,000 - $820,000 - $244,900 = $1,395,100
→ Year 3 = $2,870,000 - $820,000 - $174,900 = $1,465,100

● Tax = EBIT * Corporate tax rate

→ Year 1 Tax = $1,497,100 * 21% = $314,391
→ Year 2 Tax = $1,395,100 * 21% = $292,791
→ Year 3 Tax = $1,465,100 * 21% = $307,671
● Net Income = EBIT - Tax
→ Year 1 NI = $1,497,100 - $314,391 = $1,182,709
→ Year 2 NI = $1,395,100 - $292,791 = $1,102,129
→ Year 3 NI = $1,465,100 - $307,671 = $1,157,429

● OCF = Net income + Depreciation

→ Year 1 = $1,182,709 + $142,900 = $1,325,609
→ Year 2 = $1,102,129 + $244,900 = $1,347,029
→ Year 3 = $1,157,429 + $174,900 = $1,332,329

● Cost of Fixed Asset = Cost of new equipment = $1,000,000

● After-tax Salvage Value = Sales of asset - Corporate tax rate * (Sale of asset - Book
Value of asset)
→ AT salvage value = $437,300 - 21%*( $437,300- $437,300)= $437,300
● “Sell the equipment for book value” means that the Sales of asset = Book value of asset
→ Accumulated depreciation = Depreciation year 1 + Depreciation year 2 + Depreciation year 3
= $142,900 + $244,900 + $174,900
= $562,700
→ Book value of asset = Cost of asset - Accumulated depreciation
= $1,000,000 - $562,700
= $437,300

● Net Capital Spending = Purchase of asset - AT salvage value

→ NCS = $1,000,000 - 0 = $1,000,000
NWC: provided

● Change in Net Working Capital = NWC in the current year - NWC in the previous year
+ △NWC0 = $335,000 - $470,000 = -$135,000
 + △NWC1 = $470,000 - $515,000 = -$45,000
+ △NWC2 = $515,000 - $350,000 = 165,000
+ △NWC3 = $350,000 - $335,000 = 15,000

● Project CFs (CFFA) = OCF + NCS + △NWC

→ Year 0 CFFA = 0 + (- $1,000,000) - $135,000 = -$1,135,000
→ Year 1 CFFA = $1,325,609 + 0 - $45,000 = $1,280,609
→ Year 2 CFFA = $1,347,029 - 0 + (165,000) = $1,512,029
→ Year 3 CFFA = $1,332,329 + $437,300 + (15,000) = $1,784,629

CFFA1 CFFA2 CFFA3

● NPV= -CFFA0 + + 2+ 3
1+r (1+r ) (1+r )
$ 1,280,609 $ 1,512,029 $ 1,784,629
→ NPV= -$1,135,000 + + 2 + 3 = $2,619,618.9
1.1 1.1 1.1
+ CFFA in year 0 = Initial cost of investment
+ r: discount rate