Question

Need to know how to solve with steps.

José Garcia is thinking of importing caviar to sell to restaurants and specialty stores. He estimates that this venture will require an initial outlay of $300.000 to buy a refrigerated storage unit, which can be depreciated (straight-line) to salvage value of $50,000 in eight years. In addition, Mr. Garcia estimates that he will need S40.000 in working capital during the eight years of the project. Annual sales are estimated to be $110,000 and annual expenses of $20,000. José estimates that the marginal tax rate will 25% during the lifetime of the project. a. What is the initial outlay associated with starting the business? b. What is the annual cash flow from operations? c. What will be the terminal cash flow in year 8? d. What is the payback period for this project? e.f José requires a 16% RRR to make this investment, should she make the investment? f. What is the project's IRR? Should the project be accepted using IRR criterion?

Answer 1

a. Initial outlay = Cost of Equipment + Working Capital = $ 300,000 + $ 40,000 = $ 340,000.

b. Annual depreciation = $ ( 300,000 - 50,000 ) / 8 years = $ 31,250.

Annual EBITDA = Annual Sales - Annual Expenses = $ 110,000 - $ 20,000 = $ 90,000.

Annual cash flow from operations = EBITDA x ( 1 - t ) + Depreciation x t = $ 90,000 x 0.75 + $ 31,250 x 0.25 = $ 75,312.50

c. Terminal cash flows in year 8 = Working Capital Recapture + Equipment Salvage Value = $ 40,000 + $ 50,000 = $ 90,000.

d. Payback period = Initial outlay / Annual Cash Flows from Operations = $ 340,000 / $ 75,313 = 4.51 years.

e. NPV at 16 % discount rate = 75,312.50 x [ { 1 - ( 1 / 1.16 ) ⁸ } / 0.16 ] + 90,000 x ( 1 / 1.16 ) ⁸ - 340,000

= 75,312.50 x 4.34359 + 90,000 x 0.30503 - 340,000 = 327,126.62 + 27,452.70 - 340,000 = $ 14,579.32.

As the NPV of $ 14,579 is greater than zero, Jose should make this investment.