## Saturday, December 3, 2011

### NPV of Operating Cash Flow

Calculating NPV – Howell petroleum is considering a new project that complements its existing business. The machine required for the project costs \$1.8 million. The marketing department predicts that sales related to the project will be \$1.1 million per year for the next four years, after which the market will cease to exist. The machine will be depreciated down to zero over its four – year economic life using the straight line method. Cost of goods sold and operating expenses related to the project are predicted to be  25 percent of sales. Howell also needs to add net working capital of \$150,000 immediately. The additional net working capital will be recovered in full at the end of the project’s life. the corporate tax rate is 35 percent. The required rate of return for Howell is 16 percent. Should Howell proceed with the project?

We will begin by calculating the initial cash outlay, that is, the cash flows at time 0. To undertake the project, we will have to purchase the equipment and increase net working capital. So the cash outlay today for the project will be:

Equipment                          -\$1,800,000
NWC                                     -150,000
Total                                  -\$ 1950,000

Using the bottom-up approach to calculating the operating cash flow, we find the operating cash flow each year will be:

Sales                                      \$1,100,000
Costs                                           275,000
Depreciation                                 450,000
EBT                                           \$375,000
Tax                                               131,250
Net Income                                \$243,750

The operating cash flow is:

OCF = Net income + depreciation
OCF = \$243,750 + 450,000
OCF = \$693,650

To find the NPV of the project, we add the present value of the project cash flows. We must be sure to add back the net working capital at the end of the project life, since we are assuming the net working capital will be recovered. So, the project NPV is:

NPV = -\$1,950,000 + \$693,750(PVIFA16%,4) + \$150,000/1.164
NPV = \$74,081.48

Reference: Corporate Finance Book, Stephen A.Ross, Randolph W.Westerfield and Jeffrey Jaffe, Ninth Edition. Chapter 5, questions number 9, page 196.