Cash Flow Estimation Problems : please do not solve using excel
Household Products, Inc. manufactures a variety of household products (duh). The company is considering introducing a new detergent. The company’s CFO has collected the following information about the proposed product. (Note: You may or may not need to use all of this information. Use only the information that is relevant.)
• The project has an anticipated economic life of 4 years.
• The company will have to purchase a new machine to produce the detergent. The machine has an up-front cost (t = 0) of $2 million. The machine will be depreciated on a straight-line basis over 4 years (that is, the company’s depreciation expense will be $500,000 in each of the first four years (t = 1, 2, 3, and 4). The company anticipates that the machine will last for four years, and that after four years, its salvage value will equal zero. In other words, it will have to be scrapped.
• If the company goes ahead with the proposed product, it will have an effect on the company’s net operating working capital. At the outset, (t = 0), inventory will increase by $140,000 and accounts payable will increase by $40,000. Each working capital account will revert to its pre-project level after the project is completed (In time = 4).
• The detergent is expected to generate sales revenue of $1 million the first year (t = 1), $2 million the second year (t = 2), $2 million the third year (t = 3), and $1 million the final year (t = 4). Each year the operating costs (not including depreciation) are expected to equal 50 percent of sales revenue.
• The company expects to borrow the $2 million for the investment and estimates it will have an after-tax interest expense each year of $100,000.
• The new detergent is expected to reduce the after-tax cash flows of the company’s other detergent-based products by $250,000 per year (t = 1, 2, 3, and 4).
• The company’s overall WACC is 10 percent. However, the proposed project is riskier than the average project for Parker; the project’s WACC is estimated to be 12 percent.
• The company’s tax rate is 40 percent.
What is the net present value of the proposed project?