Houston Inc. is considering a project which involves building a new refrigerated
warehouse which will cost $7,000,000 at year = 0 and which is expected to have
before tax operating cash flows of $500,000 at the end of each of the next 20 years.
The Net Working Capital required initially is $50,000, no additional NWC is
required after year 0. The company’s corporate tax rate is 25%. Depreciation of
$350,000 is included in the before tax operating cash flow. In year 20 the asset can
be sold before tax at $75,000.
Part I: If Houston's WACC is 8 percent, what is the project’s NPV? IRR? PI?
Payback?
Determine the capital budget for Years 0 – 20 and perform the necessary capital
budget analysis.
Part II: The risk/sensitivity factor is WACC. Should WACC increase to 8.5
percent, could this influence your decision on the project? What would happen to
NPV?
To calculate the project's NPV (Net Present Value), IRR (Internal Rate of Return), PI (Profitability Index), and Payback, you will need to follow the steps below:
Part I:
1. Calculate the Net Cash Flows for each year by subtracting the taxes from the operating cash flows. The formula for net cash flow is: Cash Flow = Operating Cash Flow - Taxes.
2. Determine the Depreciation Tax Shield by multiplying the depreciation amount by the tax rate. The formula is: Depreciation Tax Shield = Depreciation * Tax Rate.
3. Calculate the Net Cash Flow After Taxes by subtracting the Depreciation Tax Shield from the Net Cash Flows. The formula is: Net Cash Flow After Taxes = Net Cash Flow - Depreciation Tax Shield.
4. Calculate the Present Value (PV) of each year's Net Cash Flow After Taxes using the WACC (Weighted Average Cost of Capital). The formula is: PV = Cash Flow / (1+ WACC)^n, where n is the year.
5. Sum up all the present values to calculate the NPV. The formula is: NPV = PV for Year 0 + PV for Year 1 + ... + PV for Year 20 - Initial Investment.
6. Calculate the IRR using the discount rate that results in NPV = 0. You can use a financial calculator, excel solver, or trial and error to find the IRR.
7. Calculate the PI by dividing the PV of the Cash Flows by the Initial Investment. The formula is: PI = (PV for Year 0 + PV for Year 1 + ... + PV for Year 20) / Initial Investment.
8. Calculate the Payback by summing the cash flows until the total is equal to or greater than the Initial Investment.
Part II:
If the WACC were to increase to 8.5%, recalculate the NPV using the new WACC in the PV calculations. Compare the new NPV with the previous NPV. If the NPV decreases, it may influence the decision on the project. A decrease in NPV suggests a less favorable investment.
Note: It's important to thoroughly understand financial concepts and equations before performing calculations like these. Consider seeking professional advice or using specialized financial software to ensure accuracy.