Esfandairi Enterprises is considering a new 3-year expansion project that requires an initial fixed asset investment of $2.28 million. The fixed asset falls into the 3-year MACRS class. The project is estimated to generate $1,750,000 in annual sales, with costs of $652,000. The project requires an initial investment in net working capital of $330,000, and the fixed asset will have a market value of $300,000 at the end of the project.
a. If the tax rate is 23 percent, what is the project’s Year 0 net cash flow? Year 1? Year 2? Year 3? (A negative answer should be indicated by a minus sign. Do not round intermediate calculations and enter your answers in dollars, not millions of dollars, rounded to two decimal places, e.g., 1,234,567.89.)
b. If the required return is 12 percent, what is the project’s NPV? (Do not round intermediate calculations and enter your answer in dollars, not millions of dollars, rounded to two decimal places, e.g., 1,234,567
The Correct Answer and Explanation is:
a. Project Net Cash Flows
- Year 0: -$2,610,000
(Initial investment in fixed assets and net working capital) - Year 1: $1,020,242.52
(Operating Cash Flow) - Year 2: $1,078,555.80
(Operating Cash Flow) - Year 3: $1,484,123.64
(Operating Cash Flow + After-tax salvage value + Recovery of net working capital)
b. Project NPV
- NPV: $217,118.79
Explanation
To evaluate the viability of Esfandairi Enterprises’ 3-year expansion project, we compute the net cash flows for each year and determine the Net Present Value (NPV) using a 12% required return.
Year 0: The project requires an initial investment of $2.28 million in fixed assets and $330,000 in net working capital (NWC), totaling a cash outflow of $2,610,000.
Years 1–3: The project generates annual sales of $1,750,000 with costs of $652,000, resulting in earnings before depreciation and tax (EBIT) of $1,098,000. Depreciation is calculated using the MACRS 3-year schedule, leading to declining tax savings each year. Operating Cash Flow (OCF) is derived as:
OCF = EBIT – Taxes + Depreciation
This results in:
- Year 1: $1,020,242.52
- Year 2: $1,078,555.80
- Year 3: $1,484,123.64
(Includes OCF, recovery of $330,000 NWC, and after-tax salvage value of $231,000 from the $300,000 residual)
Finally, we calculate the NPV by discounting each year’s cash flow at 12%. The formula used is:
NPV = ∑(Cash Flowₜ / (1 + r)ᵗ)
Where t is the year and r is the discount rate.
The resulting NPV is $217,118.79, which is positive. A positive NPV indicates that the project is expected to add value to the firm and should be undertaken.
