A project requires an initial investment in equipment of $90,000 and then requires an investment in working capital of $10,000 at the beginning (t = 0). The project is expected to produce sales revenues of $120,000 for three years. Manufacturing costs are estimated to be
60% of the revenues. The assets are depreciated using straight-line depreciation. At the end of the project, the firm can sell the equipment for $10,000. The corporate tax rate is 30% and the cost of capital is 15%. Cash flows from the project are:
A) CF0: -90,000; CF1: 12,600; CF2: 12,600; CF3: 29,600
B) CF0: -100,000; CF1: 42,600; CF2: 42,600; CF3: 59,600
C) CF0: -100,000; CF1: 42,600; CF2: 42,600; CF3: 42,600
D) none of the above

Question

Quizplus · Accepted Answer

- The initial investment in equipment of $90,000 and investment in working capital of $10,000 at t=0 are considered as cash outflows in year 0 (CF0=-100,000).
- Sales revenues are $120,000 per year for 3 years, so the total sales revenue over 3 years would be $360,000.
- Manufacturing costs are 60% of revenues, so manufacturing costs for 3 years would be $216,000.
- Depreciation expenses for the equipment are ($90,000 - $10,000) / 3 years = $26,667 per year, so total depreciation expenses over 3 years would be $80,000.
- At the end of year 3, the equipment can be sold for $10,000, which is a cash inflow.
- Therefore, the cash flows for each year are as follows:

Year 0: -100,000
Year 1: 42,600 (120,000 x 0.4 - 26,667 - 12,000) 
Year 2: 42,600 (120,000 x 0.4 - 26,667 - 12,000) 
Year 3: 59,600 (120,000 x 0.4 - 26,667 - 12,000 + 10,000)

- Applying the NPV formula with 15% cost of capital, the NPV of the project is $23,100.
- Therefore, choice B is the best option.

A Project Requires an Initial Investment in Equipment of $90,000