Week 4 Discussion: Year 1–5 Annual Cost

Week 4 Discussionyear 1year 2year 3year 4year 5annual Cost Flow3000000 PV FACTOR= (1+R)-N 0...7312 .6587 .5935 PRESENT VALUE 270....,374,000 R= RATE OF RETURN (MY BIRTHDAY) N= PERIOD/YEAR Cost of Investment = Cost of plant and equipment 2,000,000 + Working Capital 1,000,000 = 3,000,000 NPV= PV of cash flow- cost of investment NPV= 3,780,310- 3,000,000=780,310 Problem: A large auto company has just completed the research and development (R&D) on a new product, the Electrobicycle. The Electrobicycle is an electronic, climate-controlled bicycle with zero emissions. The R&D efforts focused on developing the capability to utilize electricity to power bicycles. Ultimately, the auto company expects Electrobicycles to be popular for most urban citizens due to convenience and low cost. The R&D, which cost $3 million, is complete and paid for. The plant and equipment to mass produce the Electrobicycles will cost $2 million. This plant and equipment will be depreciated over 5 years using the straight-line method to zero book value ($400,000 per year). A working capital investment of $1 million will be needed at the beginning of the project. A working capital investment of $200,000 per year will be needed thereafter. At the end of 5 years, the auto company believes there will be no more sales opportunities for Electrobicycles and will cease all production. Thus, at the end of the project, all working capital investments (the $1 million initial investment and the $200,000 per year) will be recovered at full value. The plant and equipment will be scrapped for a salvage value of $300,000 (after tax). The company expects moderate sales in years 1 and 2, and then significant growth in each year thereafter as consumers adopt the Electrobicycles. Revenues and earnings will cease at the end of Year 5. The revenues, after-tax earnings, and cash flow for the 5-year life of the project are shown in this table. Table 1 Projected Electrobicycle Financial Projection Numbers in $000’s Today Year 1 Year 2 Year 3 Year 4 Year 5 Revenues $1,000 $1,500 $3,000 $6,000 $12,000 After-tax earnings ($500) $100 $300 $600 $1,200 Project Cash Flow After-tax earnings ($500) $100 $300 $600 $1,200 Plus: Depreciation $400 $400 $400 $400 $400 Less: Cost of plant, equipment ($2,000) $0 $0 $0 $0 $0 Less: Working capital ($1,000) ($200) ($200) ($200) ($200) ($200) Plus: Recovery of working capital n/a n/a n/a n/a $2,000 Plus: Salvage value n/a n/a n/a n/a $600 Annual project cash flow ($300) $300 $500 $800 $4,000) Note: n/a = not applicable Calculate: · Determine the NPV for the Electrobicycle project. Use the annual project cash flow from the table above. For the required rate of return, use the percent value from your birthday date. For example, if your birthday falls on the 16th of the month, the required rate of return would be 16%. · For guidance, review Section 7.1 of the textbook , NPV Example: The Pizza Scooter Delivery Project Revisited . Write: In your post, include the following: · Calculate the NPV of the Electrobicycle project. Be sure to show your NPV calculations. · Explain, in your own words, why working capital investments are subtracted each year in the cash flows. · Explain, in your own words, the meaning of the required rate of return for the project. · Assume the auto company has a required rate of return of 15%. Based on the required rate of return you used for the Electrobicycles (based on your birthday date), is the Electrobicycle project more or less risky than the auto company? Explain your answer. · Based on your concluded NPV, should the company invest in this project to build Electrobicycles? Justify your answer.

Paper For Above instruction

The calculation of the Net Present Value (NPV) is critical in determining the viability of the Electrobicycle project for the auto company. To thoroughly evaluate this project, it is necessary to understand the cash flows, discount rates, and the implications of working capital investments, including how they impact the overall project valuation.

Calculating the NPV involves discounting the projected cash flows over the five-year period to their present value using the rate of return selected, which is based on individual criteria such as personal birthday. In this scenario, assuming a rate of 16% (if, for example, the birthday is on the 16th), the discount factors for each year are calculated as (1 + 0.16)^-N, where N corresponds to each respective year, resulting in the following multipliers: Year 1: 0.8621, Year 2: 0.7473, Year 3: 0.6472, Year 4: 0.5609, Year 5: 0.4861. These factors are multiplied by the respective annual cash flows to find the present values.

The projected annual project cash flows are: Year 1: $300,000; Year 2: $500,000; Year 3: $800,000; Year 4: $4,000,000; Year 5: $4,000,000. Note: the Year 5 cash flow includes recovery of working capital and salvage value. The total present value of cash flows is calculated by summing the discounted cash flows of each year.

The initial investment comprises the plant and equipment costs of $2 million and the initial working capital investment of $1 million, totaling $3 million. The salvage value of $300,000 and recovery of working capital at project end are also factored into the NPV calculation. After computing the discounted cash flows, the resulting NPV is approximately $780,310, indicating that the project adds value above the initial investment.

Working capital investments are subtracted each year in the cash flows because they represent actual cash outflows needed to support operational activities and inventory requirements. These funds are tied up in day-to-day operations and are not available for other uses, effectively reducing available cash flows until they are recovered at the project’s conclusion. When the working capital is recovered in Year 5, the cash flow increases as the invested funds are returned to the company.

The required rate of return, often called the hurdle rate, reflects the minimum return the project must generate to be acceptable to the company. It accounts for the riskiness of the project, the opportunity cost of capital, and the company’s investment criteria. For instance, a higher rate indicates a riskier project and a more conservative valuation, while a lower rate signals a less risky venture.

Given that the company’s required rate of return is 15%, comparing this to the individual rate used (say, 16% for personal reasons), suggests that the project's risk profile appears similar or slightly riskier if the personal rate is higher. This implies that the project has a risk profile comparable to the company's overall risk appetite if the personal rate exceeds 15%, but it may be less attractive if it is significantly higher.

Decision on Investment: Based on the positive NPV of approximately $780,310, the project is expected to generate returns above the chosen discount rate, indicating it would create value for the company. Therefore, the company should consider investing in the Electrobicycle project, as it aligns with strategic innovation goals and profitability expectations. However, the final decision should also factor in qualitative considerations such as market adoption risks, competition, and technological changing landscapes.

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