Reference no: EM132597031

Question - You have been asked to review an investment analysis of a 10-year project with a big upfront investment of $ 10 million and equal annual after-tax cash flows for the next 10 years. The analyst has estimated a net present value for the project of $ 1.5 million, using the cost of equity of the firm of 12% as the discount rate. You notice three errors in the valuation:

The cash flows being discounted are after taxes but before debt payments (interest and principal). The after-tax cost of debt for the firm is 4% and the firm has a debt to capital ratio of 30%.

The analyst has depreciated the initial investment of $ 10 million straight line over 10 years to a salvage value of zero. You agree with the straight line depreciation but you believe that the asset should be depreciated down to an expected salvage value at the end of the 10th year of $ 2 million.

The project is expected to have revenues of $ 15 million each year for the next 10 years and the non-cash working capital is expected to be 10% of the revenues over the entire period, with the investment in working capital being made at the beginning of each year. This investment will be fully salvaged in year 10. The tax rate is 40%.

a. Given the estimates of net present value and assumption of no salvage, what was the analyst's estimate of annual after-tax cash flow on the project?

b. What is the correct net present value for the project? (Make the necessary corrections to the cash flows and discount rates for the three errors noted.