United Pigpen is considering a proposal to manufacture high-protein hog feed. The project would require use of an existing warehouse, which is currently rented out to a neighboring firm. The next year’s rental charge on the warehouse is $125,000, and thereafter, the rent is expected to grow in line with inflation at 4% a year. In addition to using the warehouse, the proposal envisages an investment in plant and equipment of $1.35 million. This could be depreciated for tax purposes straight-line over 10 years. However, Pigpen expects to terminate the project at the end of 8 years and to resell the plant and equipment in year 8 for $450,000. Finally, the project requires an immediate investment in working capital of $375,000. Thereafter, working capital is forecasted to be 10% of sales in each of years 1 through 7. Working capital will be run down to zero in year 8 when the project shuts down. Year 1 sales of hog feed are expected to be $4.70 million, and thereafter, sales are forecasted to grow by 5% a year, slightly faster than the inflation rate. Manufacturing costs are expected to be 90% of sales, and profits are subject to tax at 25%. The cost of capital is 12%. What is the NPV of Pigpen’s project?

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Asked Nov 8, 2019
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United Pigpen is considering a proposal to manufacture high-protein hog feed. The project would require use of an existing warehouse, which is currently rented out to a neighboring firm. The next year’s rental charge on the warehouse is $125,000, and thereafter, the rent is expected to grow in line with inflation at 4% a year. In addition to using the warehouse, the proposal envisages an investment in plant and equipment of $1.35 million. This could be depreciated for tax purposes straight-line over 10 years. However, Pigpen expects to terminate the project at the end of 8 years and to resell the plant and equipment in year 8 for $450,000. Finally, the project requires an immediate investment in working capital of $375,000. Thereafter, working capital is forecasted to be 10% of sales in each of years 1 through 7. Working capital will be run down to zero in year 8 when the project shuts down. Year 1 sales of hog feed are expected to be $4.70 million, and thereafter, sales are forecasted to grow by 5% a year, slightly faster than the inflation rate. Manufacturing costs are expected to be 90% of sales, and profits are subject to tax at 25%. The cost of capital is 12%.

 

What is the NPV of Pigpen’s project?

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Expert Answer

Step 1

Note: No intermediate rounding is done. Final answer is two decimal places.

Depreciation for each of the 10 years would be $135000 ($1350000/10) using straightline method.

After tax salvage value of the plant  is calculated below:

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Book Value Cost of plant accumul ated depreciati on -$1350000-(8xS135000) -S1350000-S1080000 =S270,000

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Step 2
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Gain on sale Sale price - Book Value -$450,000-S270,000 =$180,000 After tax salvage value Gain - Tax x Gain =S180,000-25%x$180000 =$135000

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Step 3

Net Income, Cash Flow statement and...

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C G H 1 Net Income 2 Particulars 3 Reveme 4 Manufacturing cost 90% sales 5 Depreciation 6 Rent 7 Eanings Before Tax 8 Tax 9 Net Income Year 3 D3*1.05 -90%*E3 1350000/10 D6*1.04 -E3-E4-E5-E6 25%*E7 -E7-ES Year 1 4700000 90%*C3 Year 6 -G3.1.05 90%*H3 - 1350000/10 G6 1.04 -F3-F4-F5-F6 -G3-G4-G5-G6 -H3-H4-H5-H6 | -13-14-15-16| -3-J4-15-36 -25 % "H7 -H7-HS Year 5 F3 1.05 |-90%°G3 - 1350000/10 F6.1.04 Year 7 H3*1.05 |90%°13 1350000/10 1350000/10 H6-1.04 Year 2 C3*1.05 90%°D3 1350000 10 -C6 1.04 |-C3-C4-C5-C6| -D3-D4-D5-D6 -25%"D7 =D7-DS Year S -13 1.05 |-90% J3 Year 0 Year 4 E3*1.05 |90%*F3 =1350000/10 E6*104 |=1350000/10 125000 16 104 25% 17 =17-18 25%*C7 C7-CS 25%°F7 =F7-FS -25 % "G7 G7-GS 25% J7 -J7-JS

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