Question

Movies, Inc. is considering a new project producing educational movies for children. The project requires an investment in equipment of $1,800,000. The equipment will be fully depreciated using straight line depreciation over its 8 year accounting life. At the end of the project the firm expects to be able to sell the equipment for $125,000. The firm expects to sell 475,000 million videos each year for 5 years. The retail price for each video will be $20.00 and variable costs related to production are $12.00 per video. Additional fixed costs include $900,000 per year for labor, $450,000 for rent and $200,000 for all other expenses. The project also requires an additional investment in net working capital of $700,000, all of which will be returned to the firm at the end of the project. The firm’s marginal tax rate is 34% and the required return on this project is 12%, compounded quarterly. Would you recommend this project to the firm? Why or why not? Clearly explain your answer.

Answer 1

		Present Value(PV) of Cash Flow:
		(Cash Flow)/((1+i)^N)
		i=discount rate=Required Return =12%=0.12
		N=Year of cash flow
	a	Initial Outlay
	A	Investment in equipment	$1,800,000
	B	Investment in Net working Capital	$700,000
	C=A+B	Initial Outlay Associated with the project	$2,500,000
		Cash Flow in Year 1-4
	a	Annual Sales quantity(units)	475,000,000
	b	Contribution per unit=20-12	$8
	c=a*b	Total Contribution margin	$3,800,000,000
	d	Additional fixed cost for labor	-$900,000
	e	Rent expense	-$450,000
	f	Other fixed expenses	-$200,000
	g	Annual Depreciation=(1800000)/8	-$225,000
	h=c+d+e+f+g	Annual Before tax Income	$3,798,225,000
	i=h*(1-0.34)	Annual after tax Income	$2,506,828,500
	j	Add: Depreciation (Non cash expense)	$225,000
	k=i+j	After Tax Cash Flow	$2,507,053,500
		Terminal Cash Flow in Year5:							$0
	l	Annual after tax cash flow	$2,507,053,500
	m	Release of net working capital	$700,000
	n	Salvage value of equipment	$125,000
	o	Accumulated depreciation=225000*5	$1,125,000
	p	Book Value at end of 5 years	$675,000	(1800000-1125000)
	q=p-n	Loss on salvage	$550,000
	r=q*34%	Tax saving on salvage	$187,000
	s=n+r	Terminal Cash flow on salvage	$312,000
	t=l+m+s	Terminal Cash Flow in Year5:	$2,508,065,500
	N	Year	0	1	2	3	4	5
	CF	Net Cash Flow	-$2,500,000	$2,507,053,500	$2,507,053,500	$2,507,053,500	$2,507,053,500	$2,508,065,500	SUM
	PV=CF/(1.12^N)	Present Valure	-$2,500,000	$2,238,440,625	$1,998,607,701	$1,784,471,162	$1,593,277,823	$1,423,143,721	$9,035,441,031
	NPV=Sum of PV	Net Present Value	$9,035,441,031
	d	Project NPV	$9,035,441,031
		NPV is POSITIVE
		Yes, this project is recommended