As a senior analyst for Lawton Enterprise, you have been asked to evaluate a new computer hardware project with the following characteristics:
• Acquiring a computer hardware for a cost of $2,000,000.
• The computer hardware has an expected five-year life.
• The initial investment in net working capital (in Year 0) is $200,000. The investment in working capital is to be completely recovered by the end of the project’s life (in Year 5).
• The computer hardware can be depreciated on a straight-line (prime cost) basis and there is no expected salvage value after the five years.
• The produced software is expected to generate sales of $1,250,000 in Year 1. They grow at a 25% annual rate for the next two years, and then grow at a 10% annual rate for the last two years.
• Fixed operating expenses are $100,000 for Years 1-3 and $110,000 for Years 4-5.
• Variable operating expenses are 20% of sales in Years 1-2 and 25% of sales in Years 3-5.
• Lawton does not have any available space where the project can be located for five years and you anticipate to rent the required office space it would cost $65,000 per year for the life of the project. You expect that the project will need to hire three new software specialists at $50,000 (each specialist) per year (start in Year 1) for the full five years to work on the software.
• The project will use a van currently owned by Lawton. Although the van is not currently being used by Lawton, it can be rented out for $15,000 per year for five years. The book value of the van is $20,000. The van is being depreciated straight-line (with five years remaining for depreciation) and is expected to be worthless after the five years.
• Lawton’s marginal tax rate is 30%, and the discount rate is 12%.
To evaluate the new computer hardware project, we need to calculate the cash flows for each year and use the discounted cash flow (DCF) method to determine its net present value (NPV) and internal rate of return (IRR). Let's break down the information provided and calculate the cash flows step by step:
1. Initial Investment:
The cost of acquiring the computer hardware is $2,000,000, and there is an additional initial investment in net working capital of $200,000. Therefore, the total initial investment (Year 0) is $2,200,000.
2. Sales Revenue:
The sales for the software are as follows:
- Year 1: $1,250,000
- Year 2 growth: 25% of Year 1 sales ($1,250,000 x 25% = $312,500), total sales = Year 1 sales + growth = $1,250,000 + $312,500 = $1,562,500
- Year 3 growth: 25% of Year 2 sales ($1,562,500 x 25% = $390,625), total sales = Year 2 sales + growth = $1,562,500 + $390,625 = $1,953,125
- Year 4 growth: 10% of Year 3 sales ($1,953,125 x 10% = $195,312.50), total sales = Year 3 sales + growth = $1,953,125 + $195,312.50 = $2,148,437.50
- Year 5 growth: 10% of Year 4 sales ($2,148,437.50 x 10% = $214,843.75), total sales = Year 4 sales + growth = $2,148,437.50 + $214,843.75 = $2,363,281.25
3. Expenses:
- Fixed operating expenses for Years 1-3 are $100,000, and for Years 4-5, they are $110,000.
- Variable operating expenses are 20% of sales for Years 1-2 and 25% of sales for Years 3-5.
Let's calculate the cash flows for each year:
Year 0:
- Initial investment: -$2,200,000 (outflow)
Year 1:
- Sales: $1,250,000
- Fixed operating expenses: -$100,000
- Variable operating expenses: -($1,250,000 x 20%) = -$250,000
- Office space rent: -$65,000
- Software specialists: -$150,000 (3 specialists x $50,000)
- Van rental: +$15,000
- Depreciation (straight-line): -$2,000,000 / 5 = -$400,000
- Tax Shield (depreciation x tax rate): +$400,000 x 30% = +$120,000
Year 2:
- Sales: $1,562,500
- Fixed operating expenses: -$100,000
- Variable operating expenses: -($1,562,500 x 20%) = -$312,500
- Office space rent: -$65,000
- Software specialists: -$150,000
- Van rental: +$15,000
- Depreciation: -$400,000
- Tax Shield: +$120,000
Year 3:
- Sales: $1,953,125
- Fixed operating expenses: -$100,000
- Variable operating expenses: -($1,953,125 x 25%) = -$488,281.25
- Office space rent: -$65,000
- Software specialists: -$150,000
- Van rental: +$15,000
- Depreciation: -$400,000
- Tax Shield: +$120,000
Year 4:
- Sales: $2,148,437.50
- Fixed operating expenses: -$110,000
- Variable operating expenses: -($2,148,437.50 x 25%) = -$537,109.37
- Office space rent: -$65,000
- Software specialists: -$150,000
- Van rental: +$15,000
- Depreciation: -$400,000
- Tax Shield: +$120,000
Year 5:
- Sales: $2,363,281.25
- Fixed operating expenses: -$110,000
- Variable operating expenses: -($2,363,281.25 x 25%) = -$590,820.31
- Office space rent: -$65,000
- Software specialists: -$150,000
- Van rental: +$15,000
- Depreciation: -$400,000
- Tax Shield: +$120,000
4. Calculate the Net Cash Flow:
To calculate the net cash flow for each year, sum up the cash inflows and subtract the cash outflows.
Net Cash Flow = Sales - Fixed operating expenses - Variable operating expenses - Office space rent - Software specialists - Van rental + Depreciation - Tax Shield
Now that we have calculated the net cash flows for each year, we can use the DCF method to calculate the NPV and IRR.
The DCF method uses the concept of discounting future cash flows back to the present value using a specified discount rate, which in this case is 12%. Add up the present values of all cash flows to obtain the NPV.
To calculate the discounted cash flows for each year, divide the net cash flow for that year by (1 + discount rate)^year.
DCF (Year X) = Net Cash Flow (Year X) / (1 + Discount Rate)^Year
Sum up the discounted cash flows for all years to calculate the NPV.
Finally, compare the NPV to zero. If it's positive, the project is considered financially viable. If it's negative, the project may not be worth pursuing.
To calculate the IRR, use the NPV equation with the discount rate as an unknown variable and solve for the discount rate that makes the NPV equal to zero.