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Blue Buffalo has a new 4-year project to evaluate. The Installed Cost of the project’s long-term...

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Finance

Blue Buffalo has a new 4-year project to evaluate. The InstalledCost of the project’s long-term assets is $200 million. The projectalso requires an initial Net Working Capital increase of $30million (no further changes in NWC are required) when implementedat t=0. This initial Net Working Capital of $30 million is alsoassumed to be fully recovered when the project is terminated at t=4years. The project’s assets fit into a 3 year IRS MACRSdepreciation schedule as follows: Year 1 -- 33%; Year 2 -- 45%;Year 3 -- 15%; Year 4 -- 7%. The project will be terminated exactlyfour years from today (t=4) and this project’s assets will then besold at an estimated $40 million salvage value. If the project isaccepted it will increase the firm’s revenue and operating costs by$110 million and $40 million, respectively, for each of thefollowing four years (t=1 through t=4). The corporate tax rate is40%. The cost of capital for this project is r=12% per year. Thisis a stand alone project. Calculate the NPV and IRR. Should thisproject be accepted or rejected?

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4.2 Ratings (886 Votes)

Formula Year (n) 0 1 2 3 4
Initial investment (II)                     200
Revenue increase ('R)                       110                      110                               110                        110
Op.cost increase (OC)                          40                         40                                 40                          40
3-year MACRS dep. Schedule Depreciation rate ('r) 33% 45% 15% 7%
II*r Depreciation (D)                          66                         90                                 30                          14
R-OC-D EBIT                            4                      (20)                                 40                          56
EBIT*(1-Tax rate) After-tax EBIT                            2                      (12)                                 24                          34
Add: depreciation (D)                          66                         90                                 30                          14
After-tax EBIT + D Operating Cash Flow (OCF)                          68                         78                                 54                          48
NWC change                     (30)                          30
salvage value*(1-Tax rate) After-tax salvage value (SV)                          18
SV + NWC + FCF - II Free Cash Flow (FCF)                   (230)                          68                         78                                 54                          96
1/(1+d)^n Discount factor @ 12%                 1.000                    0.893                   0.797                           0.712                    0.636
FCF*Discount factor PV of FCF             (230.00)                    61.07                   62.18                           38.44                    60.76
Sum of all PVs NPV                 (7.56)
Using IRR() function and FCFs IRR 10.49%

The project should not be accepted as it has a negative NPV and its IRR is less than the cost of capital of 12%. It is a loss-making project.
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Transcribed Image Text

Blue Buffalo has a new 4-year project to evaluate. The InstalledCost of the project’s long-term assets is $200 million. The projectalso requires an initial Net Working Capital increase of $30million (no further changes in NWC are required) when implementedat t=0. This initial Net Working Capital of $30 million is alsoassumed to be fully recovered when the project is terminated at t=4years. The project’s assets fit into a 3 year IRS MACRSdepreciation schedule as follows: Year 1 -- 33%; Year 2 -- 45%;Year 3 -- 15%; Year 4 -- 7%. The project will be terminated exactlyfour years from today (t=4) and this project’s assets will then besold at an estimated $40 million salvage value. If the project isaccepted it will increase the firm’s revenue and operating costs by$110 million and $40 million, respectively, for each of thefollowing four years (t=1 through t=4). The corporate tax rate is40%. The cost of capital for this project is r=12% per year. Thisis a stand alone project. Calculate the NPV and IRR. Should thisproject be accepted or rejected?

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