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8. The Volunteer Company (VC) produces electrical switching components and is considering manufacturing a new component that will require new equipment. The production of this

8. The Volunteer Company (VC) produces electrical switching components and is considering manufacturing a new component that will require new equipment. The production of this component will require $1,500,000 in net working capital to start and additional net working capital investments each year equal to 15 percent of the projected sales increases for the following year. Total fixed costs are $1,350,000 per year, variable production costs are $225 per unit and the units are priced at $345 each. The equipment needed to begin production has an installed cost of $23,000,000. The equipment is considered to qualify as seven-year MACRS property. In five years, the equipment can be sold for 20 percent of its acquisition cost. VC is in the 35 percent marginal tax bracket and has a required return on all its projects of 18 percent. Based on the preceding project estimates, answer the following questions:

Questions

A. What is the total cash flow of the project for Year 3?

B. What is the NPV of the project?

C. What is the IRR of the project?

D. Should VC begin this project?

Explain Note: An income statement must be prepared for each year. Beginning with the initial cash flow at time zero, the project will require an investment in equipment. The project will also require an investment in net working capital. The Net will be Year 1 sales. To assist in your calculation, total sales per year are provided. To calculate depreciation, use the original equipment cost of $23 million times the appropriate MACRS depreciation each year. To determine the after-tax salvage value, the book value of the equipment must be determined. Book value for each year is the purchase price of the equipment ($23 million) less accumulated depreciation. As a check, ending book value for year 5= $5,131,300. Also the capital spending for year 5= (equipment cost x 20% = $4.6 million). After-tax salvage value = $4,600,000 + ($5,131,300 - 4,600,000) (.35) = $4,785,955.

Increase in Net Working Capital for Year 1 = .15($43,815,000 - $37,260,000) = $983,250; this increase is negative given the increase in sales for year 2. Net Working Capital Increases for the remaining years are positive because sales are declining.

CONTINUED 8 The required cash flow at the beginning of the project: Equipment purchase price = $23,000,000 Change in Net Working Capital = 1,500,000 Total cash flow (out) = $24,500,000

Use the following format to calculate the total cash flow. Enter the missing values (Your instructor has provided certain calculations to get you started)

Year

1

2

3

4

5

Ending book value

$19,713,300

$5,131,300

Sales

$37,260,000

$43,815,000

$39,675,000

$33,810,000

$28,980,000

Variable costs

24,300,000

Fixed costs

1,350,000

Depreciation

3,286,700

EBIT

8,323,300

Taxes

2,913,155

Net income

5,410,145

Depreciation

3,286,700

Operating cash flow

$8,696,845

$10,999,945

$9,500,445

$7,771,945

$6,393,365

Net cash flows

Operating cash flow

$8,696,845

Change in NWC

983,250

621,000

Capital spending

0

0

0

0

4,785,955

Total cash flow

$7,713,595

$11,437,320

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