Question

United Pigpen is considering a proposal to manufacture high-protein hog feed. The project would require use of an existing warehouse, which is currently rented out to a neighboring firm. The next year’s rental charge on the warehouse is $110,000, and thereafter, the rent is expected to grow in line with inflation at 4% a year. In addition to using the warehouse, the proposal envisages an investment in plant and equipment of $1.26 million. This could be depreciated for tax purposes straight-line over 10 years. However, Pigpen expects to terminate the project at the end of 8 years and to resell the plant and equipment in year 8 for $420,000. Finally, the project requires an immediate investment in working capital of $360,000. Thereafter, working capital is forecasted to be 10% of sales in each of years 1 through 7. Working capital will be run down to zero in year 8 when the project shuts down. Year 1 sales of hog feed are expected to be $4.40 million, and thereafter, sales are forecasted to grow by 5% a year, slightly faster than the inflation rate. Manufacturing costs are expected to be 90% of sales, and profits are subject to tax at 25%. The cost of capital is 12%.

What is the NPV of Pigpen’s project? (Do not round intermediate calculations. Enter your answer in dollars not in millions, rounded to the nearest whole dollars.)

Answer 1

Tax rate		25%
Calculation of annual depreciation
Depreciation		Year-1	Year-2	Year-3	Year-4	Year-5	Year-6	Year-7	Year-8	Total
Cost		$        1,260,000	$       1,260,000	$        1,260,000	$        1,260,000	$       1,260,000	$        1,260,000	$   1,260,000	$   1,260,000
Dep Rate		10.00%	10.00%	10.00%	10.00%	10.00%	10.00%	10.00%	10.00%
Depreciation		$           126,000	$          126,000	$           126,000	$           126,000	$           126,000	$           126,000	$      126,000	$      126,000	$ 1,008,000
Calculation of after-tax salvage value
Cost of machine			$       1,260,000
Depreciation			$       1,008,000
WDV			$          252,000
Sale price			$          420,000
Profit/(Loss)			$          168,000
Tax			$             42,000
Sale price after-tax			$          378,000
Calculation of annual operating cash flow
		Year-1	Year-2	Year-3	Year-4	Year-5	Year-6	Year-7	Year-8
Sale		$        4,400,000	$       4,620,000	$        4,851,000	$        5,093,550	$       5,348,228	$        5,615,639	$   5,896,421	$   6,191,242
Less: Operating Cost		$        3,960,000	$       4,158,000	$        4,365,900	$        4,584,195	$       4,813,405	$        5,054,075	$   5,306,779	$   5,572,118
Contribution		$           440,000	$          462,000	$           485,100	$           509,355	$          534,823	$           561,564	$      589,642	$      619,124
Less: Rent foregone		$           110,000	$          114,400	$           118,976	$           123,735	$           128,684	$           133,832	$      139,185	$      144,752
Less: Depreciation		$           126,000	$          126,000	$           126,000	$           126,000	$           126,000	$           126,000	$      126,000	$      126,000
Profit before tax		$           204,000	$          221,600	$           240,124	$           259,620	$          280,138	$           301,732	$      324,457	$      348,372
Tax@25%		$             51,000	$             55,400	$             60,031	$             64,905	$             70,035	$             75,433	$        81,114	$        87,093
Profit After Tax		$           153,000	$          166,200	$           180,093	$           194,715	$          210,104	$           226,299	$      243,343	$      261,279
Add Depreciation		$           126,000	$          126,000	$           126,000	$           126,000	$           126,000	$           126,000	$      126,000	$      126,000
Cash Profit after-tax		$           279,000	$          292,200	$           306,093	$           320,715	$          336,104	$           352,299	$      369,343	$      387,279
Calculation of working capital movement
Working capital-opening	$                   -	$           360,000	$          440,000	$           462,000	$           485,100	$           509,355	$           534,823	$      561,564	$      589,642
Closing working capital	$        360,000	$           440,000	$          462,000	$           485,100	$           509,355	$           534,823	$           561,564	$      589,642	$                 -
Movement	$        360,000	$             80,000	$             22,000	$             23,100	$             24,255	$             25,468	$             26,741	$        28,078	$     (589,642)
Calculation of NPV
						12.00%
Year		Capital	Working capital	Operating cash	Annual Cash flow	PV factor	Present values
0		$      (1,260,000)	$         (360,000)		$      (1,620,000)	1.0000	$      (1,620,000)
1			$           (80,000)	$           279,000	$           199,000	0.8929	$           177,679
2			$           (22,000)	$           292,200	$           270,200	0.7972	$           215,402
3			$           (23,100)	$           306,093	$           282,993	0.7118	$           201,429
4			$           (24,255)	$           320,715	$           296,460	0.6355	$           188,406
5			$           (25,468)	$           336,104	$           310,636	0.5674	$           176,263
6			$           (26,741)	$           352,299	$           325,558	0.5066	$           164,938
7			$           (28,078)	$           369,343	$           341,265	0.4523	$           154,371
8		$           378,000	$          589,642	$           387,279	$        1,354,921	0.4039	$           547,230
					Net Present Value		$           205,716