Exercise1:

ANALYZING A PROJECT WITH FRONT-LOADED EARNINGS

Wind Power Inc. builds and operates wind farms that generate electrical power using windmills.
The firm has wind farms throughout the Southwest, including Texas, New Mexico, and
Oklahoma. In the spring of 2015, the firm was considering an investment in a new monitoring
system that costs $6 million per wind farm to install. The new system is expected to contribute
to firm EBITDA via annual savings of $4.25 million in Year 1, $2.9 million in Year 2, and $1 million
in Year 3.

Wind Power’s chief financial officer is interested in investing in the new system but is concerned
that the savings from the system are such that the immediate impact of the project is so
accretive to the firm’s earnings that the individual unit managers will adopt the investment even
though it may not be expected to earn a positive NPV. Moreover, the firm has just moved to an
economic profit–based bonus system, and the CFO fears that the project may also make the
individual economic profits improve dramatically in the short term—a development that would
provide an added incentive for the wind-farm managers to take on the project.

a. Calculate the project’s expected NPV and IRR, assuming that the cost of capital for the project
is 15%, the firm faces a 30% marginal tax rate, it uses straight-line depreciation for the new
investment over a three-year project life, and it has a zero salvage value.

b. Calculate the annual economic profits for the investment for Years 1 through 3. What is the
present value of the annual economic profit measures discounted using the project’s cost of
capital? What potential problems do you see for the project?

Excercise 2:

ECONOMIC PROFIT AND NPV

Steele Electronics is considering investing in a new component that requires a $100,000 investment in
new capital equipment, as well as additional net working capital. The investment is expected to
provide cash flows over the next five years. The anticipated earnings and project free cash flows for
the investment are found in the table below.

a. Assuming a project cost of capital of 11.24%, calculate the project’s NPV and IRR.

b. Steele is considering the adoption of economic profit as a performance evaluation tool. Calculate
the project’s annual economic profit using the invested capital figures found in the table. How are your
economic profit estimates related to project’s NPV?

c. How would your assessment of the project’s worth be affected if the economic profits in 2016
and 2017 were both negative? (No calculations required.)

Project pro-forma income statement

 2016 2017 2018 2019 2020

Revenues 100000 105000 110250 115763 121551

Less: COGS -40000 -42000 -44100 -46305 -48620

Gross Profit 60000 63000 66150 69458 72930

Less: Oper. -20000 -21000 -22050 -23153 -24310

Exp

Less: Dep. -20000 -20000 -20000 -20000 -20000

Exp.

Net Oper. 20000 22000 24100 26305 28620

Income

Less: Int. Exp -3200 -3200 -3200 -3200 -3200

Earnings 16800 18800 20900 23105 25420

before tax

Less: tax -5040 -5640 -6270 -6932 -7626

Net income 11760 13160 14630 16173 17794

Project Free cash flows

2015 2016 2017 2018 2019 2020

Net Oper. 20000 22000 24100 26305 28620

Inc.

Less: taxes -6000 -6600 -7230 -7892 -8586

NOPAT 14000 15400 16870 18414 20034

Plus: 20000 20000 20000 20000 20000

depreciation

Less: CAPEX -100000

Less: change -5000 -250 -263 -276 -289 6078

in net
working
capital
Project free -105000 33750 35138 36594 38124 46112
cash flow

Invested 105000 85250 65513 45788 26078

capital