LEE Corporation intends to purchase equipment for $1,500,000. The equipment has a 5-year useful life and will

Question

be depreciated on a straight-line basis. Addition of the equipment requires additional working capital of
$20,000.

The $20,000 is expected to be recaptured at the end of the project. LEE's marginal tax rate is 40%. Use of
the equipment is expected to change the company's reported EBIT by $600,000 in year one, $700,000 in year two,
$550,000 in year three, $200,000 in year four, and $100,000 in year five. Due to changing market conditions, the
equipment did have a salvage value of $100,000 at the end of year five.
a. Calculate the initial outlay and the incremental free cash flows over the life of the project.
b. If the risk-adjusted discount rate for this project is 20%, calculate the project's net present value and internal
rate of return and comment on the acceptability of the project.

Answer 1

a. Initial Outlay = $1,500,000 + $20,000 = $1,520,000
Incremental Free Cash Flows:
Year 1 Year 2 Year 3 Year 4 Year 5
EBIT $600,000 $700,000 $550,000 $200,000 $100,000
Less Taxes (40%) 240,000 280,000 220,000 80,000 40,000
Plus Depreciation 300,000 300,000 300,000 300,000 300,000
Operating Cash Flow $660,000 $720,000 $630,000 $420,000 $360,000
Free Cash Flow $660,000 $720,000 $630,000 $420,000 $360,000
Salvage Value $100,000
Minus Tax on Gain -40,000
Plus Recovery of
Working Capital
20,000
Terminal Cash Flow $80,000
Total Final Year Cash
Flow $440,000
b. NPV = $273,956 and the project is acceptable since the NPV is positive.
IRR = 28.73% and the project is acceptable since the IRR exceeds the required return.