Problem:
Steele Electronics is considering an investment in a new component that requires a $100,000 investment in new capital equipment, as well as additional net working capital. The investment is expected to provide cash flows over the next five years. The anticipated earnings and project free cash flows for the investment are found in the table.
1. Assuming a project cost of capital of 11.24%, calculate the project's NPV and IRR.
2. Steele is considering the adoption of economic profit as a performance evaluation tool. Calculate the project's annual economic profit using the invested capital figures found in the table. How are your economic profit estimates related to the project's NPV?
| Project Pro Forma Income Statements |
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
2006 |
2007 |
2008 |
2009 |
2010 |
| Revenues |
|
|
$100,000 |
$105,000 |
$110,250 |
$115,763 |
$121,551 |
| Less: Cost of goods sold |
|
-40,000 |
-42,000 |
-44,100 |
-46,305 |
-48,620 |
| Gross Profit |
|
|
$60,000 |
$63,000 |
$66,150 |
$69,458 |
$72,930 |
| Less: Operating expense |
|
-20,000 |
-21,000 |
-22,050 |
-23,153 |
-24,310 |
| Less: Depreciation expense |
|
-20,000 |
-20,000 |
-20,000 |
-20,000 |
-20,000 |
| Net operating income |
|
20,000 |
22,000 |
24,100 |
26,305 |
28,620 |
| Less: Interest expense |
|
($3,200) |
($3,200) |
($3,200) |
($3,200) |
($3,200) |
| Earnings before taxes |
|
16,800 |
18,800 |
20,900 |
23,105 |
25,420 |
| Less: Taxes |
|
|
($5,040) |
($5,640) |
($6,270) |
($6,932) |
($7,626) |
| Net Income |
|
|
11,760 |
13,160 |
14,630 |
16,173 |
17,794 |
| Project Free cash flows |
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
2005 |
2006 |
2007 |
2008 |
2009 |
2010 |
| Net operating income |
|
$20,000 |
$22,000 |
$24,100 |
$26,305 |
$28,620 |
| Less:Taxes |
|
|
-6,000 |
-6,600 |
-7,230 |
-7,892 |
-8,586 |
| NOPAT |
|
|
|
$14,000 |
$15,400 |
$16,870 |
$18,413 |
$20,034 |
| Plus: Depreciation |
|
|
20,000 |
20,000 |
20,000 |
20,000 |
20,000 |
| Less: CAPEX |
|
($100,000) |
|
|
|
|
|
| Less: Change in NWC |
-5,000 |
-250 |
-263 |
-276 |
-289 |
6,078 |
| Project free cash flow |
($105,000) |
$33,750 |
$35,138 |
$36,594 |
$38,124 |
$46,112 |
| Invested capital |
|
|
$105,000 |
$85,250 |
$65,513 |
$45,788 |
$26,078 |
3. How would your assessment of the project's worth be affected if the economic profits in 2006 and 2007 were both negative? (No calculations required)