Problem: Calculate on the diff
Problem: Calculate on the difference between FCF Do –FCF Don’t Do
Prepare a template of doing the project and then a secondtemplate of not doing the project
Assumptions change
If you don’t do the project you will sell the land in Y0
Compare the two and calculate incremental NPV
Sunk costs
Ignore, not incremental
$50 spent two years ago, we are not getting back
Given Information:
2 year project
Capital required for P&E = $2500 in Y0
WC = $550 in Y1 and $600 in Y2. Total not incremental WC &required at beginning of the year
Salvage value of P&E at end of 2 years = $900
Depreciation in each of first 2 years = $1,000
Production is 1,000 units per year.
Assume revenue & costs are all incurred at the end of eachyear
Price = $2 / unit in Y1 and increases at a rate of 20%
Operating costs in Y1 = $400, Y2 = $500
Company owns land on which to build a plant which has a bookvalue of $300. The current market value is $300 but itis expected to rise at an annual rate of 5%. The land will be soldafter 2 years.
Company originally planned to start the project 2 years ago andspent $50 in planning, but shelved it.
Tax rate = 34%
Cost of capital = 15%
Tax on asset sale
Profit / loss = Sale Proceeds – Book value
Book value = Purchase price – accumulated depreciation
Suppose you bought equipment for $2,500, depreciated it for twoyears at $1,000 per year and sell it for $900 at the end of thesecond year
Purchase price = $2,500
Accumulated depreciation = $2,000
Book value = $2,500 – 2,000 = $500
Taxable profit in Y2 = $900 – 500 = $400
____________________________________________
Include in the template:
Working Capital
Year 0,1,2
Revenue
Cash Cost
Depreciation of Equiptment
Profit/loss from asset sale
Equipment
Land
Taxable operating income
Tax on Operating income
Net oper profit after tax (NOPAT)
Depreciation of Equipment
Profit/Loss from asset sale
Equipment
Land
Operating Cash Flow
Changes In Working Capital
Capital Expenditure
Equipmeent
Land
Free Cash Flow to all capital
Answer:
| Year | Revenue | Operating costs | Working Capital | Depriciation | Profit Before Tax | Tax(@34%) | Profit After Tax | Depreciation | Cash Flow | PV Factor(@15%) | PV of Cash Flow |
| 1 | 2000 | (400) | (550) | (1000) | 50 | (17) | 33 | 1000 | 1033 | 0.870 | 898.71 |
| 2 | 2400 | (500) | (50) | (1000) | 850 | (289+136)=(425) | 425 | 1000 | 1425+900=2325 | 0.756 | 1757.7 |
| TOTAL | 2656.41 |
Year 1 revenue = 1000*2 = $2000
Year 1 revenue = 1000*(2.4) = $2400 (20% increase in price)
Tax on profit on sale of P&E = 900(sale) – 500(BookValue)=400(profit)*(0.34)=$136
Working Capital is total, therefore , for year 2, WC=600-550=$50
$900 salvage value is added to the cash flow.
$300 value of land is an asset and it is not adeterminant for the taking up of the project as the company alreadyowns the land and has not bought it for the purpose of theproject.
The $50 spent 2 years back would have been taken intoaccount (P&L account) because it has already beenshelved.
The initial investment is $2500
PV of future cash flows from the project =$2656.41
Therefore, NPV of the project is $156.41.
The incremental cash flow in year 1 is $1033(PV=$898.71) and in year 2 it is $2325(PV=$1757.7)
If we don’t do the project then we would get $300 inyear 0.
If we do it then,
| Year | Value | PV Factor @ 15% | PV |
| 1 | 300*(1.05)=315 | 0.870 | 274.05 |
| 2 | 315*(1.05)=330.75 | 0.756 | 250.047 |
The land will be sold at $330.75 after 2 years, which at year 0has a value of $250.047. Adding to this the NPV of the projectundertaken,i.e, $156.41. Total equals$406.457.
It is better to take up the project than selling off the landbecause if the project is taken there would be a benfit of$106.457(406.457-300).
Note: Brackets indicate negative number orsubtraction.
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