Assignment: Cupcake Corp. is considering an investment of $40 million in plant and machinery. This is expected to produce sales of $23 million in year 1, $26 million in year 2, and $30 million in year 3. Subsequent sales are expected to increase by 10% each year for the remaining 2 years. The plant and machinery will be scrapped after 5 years with a salvage value of $10 million. The property and machinery belong to the 3 year recovery period class for depreciation purposes (MACRS). Cost of goods sold (COGS) is expected to be $8 million in year 1, $14 million in year 2, and to increase at 9% each year for the remaining 3 years. Fixed operating expenses are $1,000,000 per year. Year-end net working capital (NWC) is given below. The corporate tax rate is 40%.
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k = 000s
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0
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1
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2
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3
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4
|
5
|
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NWC
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500k
|
700k
|
800k
|
800k
|
500k
|
0
|
Question 1: Calculate the free cash flows for time 0 through time 5.
Question 2: Calculate the net present value (NPV) for a 12% cost of capital.
Question 3: Find the internal rate of return (IRR).
Question 4: Calculate the sensitivity of the investment to a change in the cost of capital (it could be as low as 8% or as high as 16%).
Question 5: Should Cupcake make the investment? Why or why not?
Comments:
• You need to consider the added investment in net working capital (NWC) for each period. The problem gives the total amount of NWC for that period. Cupcake initially invests $500,000 in NWC. At the end of the first year, NWC increases to 600,000 so the firm has increased its investment in NWC by $100,000. This process continues over the project’s life until all of the NWC is returned in last year.
Taxes: The project is part of a larger firm, so any operating losses can be used to offset gains in other areas. This would produce a tax savings for that year.