CGX Transmitters is developing a 2nd generation optical transmitter. Their finance department is on a team-building retreat in the Pocono Mountains. The CEO needs the capital budget on his desk tonight. He knows that you are taking FIN 305W, and that you can complete the budget that the finance group started. You have the following information:
– The project will last for four years.
– The initial investment in equipment is $24 million. The firm will use a straight line depreciation schedule in years one to four, with the book value of the equipment going down from $24 million in year zero down to a book value of $4 million in year four. (Hint: Don’t forget about the after-tax salvage value of equipment in your NPV calculations!)
– The salvage value (re-sale value) of the equipment will be $8 million in year four.
– The firm spent $14.5 million on R&D last year in order to research the technology behind the 2nd generation transmitter.
– The accounting department will assign a $0.2 million administration costs per year for years one to four. You check with them, and they give you the following breakdown: $75,000 a year for accounting services to produce paperwork necessary to run the project and comply with federal and state regulations, and $125,000 towards the overall costs of maintaining the firm’s headquarters. Even though the headquarters will not be involved with running this project, they argue that the cost of the headquarters has to be spread over all existing projects. Both numbers are net of taxes (i.e. taxes have already been applied).
– If you undertake this project, operating income before tax of the 1st generation optical transmitter will decline by an annual amount of $0.6 million for each of the next four years – The tax rate is 35%.
– The cost of capital is 9%.
– Assume that the firm’s other projects yield a positive income before tax.
Additionally, the following information is compiled by the accounting and marketing department (in $ million):
Year Net working capital Sales Cost of Goods Sold
0 1.3 0 0
1 2.8 9 4
2 4.2 10 4
3 3.8 15 6
4 0 13 5
Question 1 (60 points)
Provide a complete pro-forma analysis with the project OCF, taxes, capital investment, side effects and project net cash flow in year 0, 1, 2, 3, 4. Provide all steps and underline your final net cash flow answers. The pro-forma analysis should be well organized, complete, and readable so that it can be passed by to the CFO’s desk tomorrow.
Question 2 (10 points)
What is the NPV of the project? Should the project be started?
Question 3 (10 points)
What are the project payback period, discounted payback period, and IRR?
Question 4 (10 points)
What will be the NPV if the company uses accelerated depreciation instead (3 year MACRS): the $20 million depreciation will be applied using the 3 year MACRS formula:
Year 3 year MACRS
Hint: You do not need to re-do the complete pro-forma analysis to find the NPV with this alternative depreciation schedule.
Question 5 (10 points)
The CFO is not completely sure of the effect of this project on operating income before tax of the 1st generation optical transmitter. He asks for NPV projections for the following two scenarios: (A) if the operating income before tax of the 1st generation optical transmitter does not decline, and (B) if it suffers a much sharper decline by $1.5 million for each of the next four years.
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