Revenues generated by a new fad product are forecast as follows:YearRevenues1$50,000235,000330,000420,000Thereafter0Expenses are expected to be 40% of revenues, and working capital required in each year is expected to be 20% of revenues in the following year. The product requires an immediate investment of $60,000 in plant and equipment.a. What is the initial investment in the product? Remember working capital.b. If the plant and equipment are depreciated over 4 years to a salvage value of zero using straight-line depreciation, and the firm’s tax rate is 20%, what are the project cash flows in each year? Assume the plant and equipment are worthless at the end of 4 years.c. If the opportunity cost of capital is 10%, what is the project's NPV?d. What is the project IRR?

Question
Asked Nov 7, 2019
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Revenues generated by a new fad product are forecast as follows:

Year Revenues
1 $50,000
2 35,000
3 30,000
4 20,000
Thereafter 0

Expenses are expected to be 40% of revenues, and working capital required in each year is expected to be 20% of revenues in the following year. The product requires an immediate investment of $60,000 in plant and equipment.

a. What is the initial investment in the product? Remember working capital.

b. If the plant and equipment are depreciated over 4 years to a salvage value of zero using straight-line depreciation, and the firm’s tax rate is 20%, what are the project cash flows in each year? Assume the plant and equipment are worthless at the end of 4 years.

c. If the opportunity cost of capital is 10%, what is the project's NPV?

d. What is the project IRR?

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Expert Answer

Step 1

Part a:
Given that the product requires an immediate investment of $60,000 in plant and equipment.
The working capital required in each year is expected to be 20% of revenues in the following year, and the revenue in the year 1 is $50,000.

Step 2

Answer: The initial investment in the product is $70000

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So, the initial investment in the product=Immediate investment in plant and equipment Working capital investment >Initial investment 60000+20%x50000=70000

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Step 3
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Part b: Annual Net Cash Flow (Revenues - Expenses Depreciation) x (1-Tax Rate) Depreciation Change in Working Capital For straight line depreciation, per year depreciation value will be: (Total value Salvage value) Number of years of useful life Here, the depreciation per year (60000-0) 4=15000 Given that the expenses are expected to be 40% of revenues and the firm's tax rate is 20%

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