Question

Yeatman Co. is considering an investment that will have the following sales, variable costs, and fixed operating costs:

	Year 1	Year 2	Year 3	Year 4
Unit sales	4,800	5,100	5,000	5,120
Sales price	$22.33	$23.45	$23.85	$24.45
Variable cost per unit	$9.45	$10.85	$11.95	$12.00
Fixed operating costs	$32,500	$33,450	$34,950	$34,875

This project will require an investment of $20,000 in new equipment. Under the new tax law, the equipment is eligible for 100% bonus deprecation at t = 0, so it will be fully depreciated at the time of purchase. The equipment will have no salvage value at the end of the project’s four-year life. Yeatman pays a constant tax rate of 25%, and it has a weighted average cost of capital (WACC) of 11%. Determine what the project’s net present value (NPV) would be under the new tax law.

Determine what the project’s net present value (NPV) would be under the new tax law.

$61,554

$58,989

$41,036

$51,295

Now determine what the project’s NPV would be when using straight-line depreciation $ -----------------

Using the --------------------------- depreciation method will result in the highest NPV for the project.

No other firm would take on this project if Yeatman turns it down. How much should Yeatman reduce the NPV of this project if it discovered that this project would reduce one of its division’s net after-tax cash flows by $500 for each year of the four-year project?

$1,706

$1,551

$931

$1,318

The project will require an initial investment of $20,000, but the project will also be using a company-owned truck that is not currently being used. This truck could be sold for $9,000, after taxes, if the project is rejected. What should Yeatman do to take this information into account?

The company does not need to do anything with the value of the truck because the truck is a sunk cost.

Increase the NPV of the project by $9,000.

Increase the amount of the initial investment by $9,000.

Answer 1

1). NPV = 51,295

Formula	Year (n)	0	1	2	3	4
	Unit sales (u)		4,800	5,100	5,000	5,120
	Sales price per unit (p)		22.33	23.45	23.85	24.45
	Variable cost per unit (vc)		9.45	10.85	11.95	12.00
	Fixed operating costs (FC)		32,500	33,450	34,950	34,875
u*p	Sales (S)		1,07,184	1,19,595	1,19,250	1,25,184
u*vc	Variable cost (VC)		45,360	55,335	59,750	61,440
	Fixed cost (FC)		32,500	33,450	34,950	34,875
100% dep. At the time of purchase	Depreciation (D)	(20,000)	-
S - VC - FC - D	EBIT	(20,000)	29,324	30,810	24,550	28,869
EBIT*(1-Tax rate)	Net income	(15,000)	21,993	23,108	18,413	21,652
	Depreciation	20,000	-
Net income + Depreciation	OCF	5,000	21,993	23,108	18,413	21,652
1/(1+d)^n	Discount factor @ 11%	1.000	0.901	0.812	0.731	0.659
OCF*Discount factor	PV of cash flows	5,000	19,814	18,755	13,463	14,263
Sum of all PVs	Total PV	71,294
	Less: initial investment	20,000
Total PV - Initial investment	NPV	51,294

Note: there is a difference of 1 in the answer which could be due to rounding off of numbers.

2). NPV (with SL depreciation) = 39,164

Formula	Year (n)	1	2	3	4
	Unit sales (u)	4,800	5,100	5,000	5,120
	Sales price per unit (p)	22.33	23.45	23.85	24.45
	Variable cost per unit (vc)	9.45	10.85	11.95	12.00
	Fixed operating costs (FC)	32,500	33,450	34,950	34,875
u*p	Sales (S)	1,07,184	1,19,595	1,19,250	1,25,184
u*vc	Variable cost (VC)	45,360	55,335	59,750	61,440
	Fixed cost (FC)	32,500	33,450	34,950	34,875
Cost of equipment/4	Depreciation (D)	5,000	5,000	5,000	5,000
S - VC - FC - D	EBIT	24,324	25,810	19,550	23,869
EBIT*(1-Tax rate)	Net income	18,243	19,358	14,663	17,902
	Depreciation	5,000
Net income + Depreciation	OCF	23,243	19,358	14,663	17,902
1/(1+d)^n	Discount factor @ 11%	0.901	0.812	0.731	0.659
OCF*Discount factor	PV of cash flows	20,940	15,711	10,721	11,792
Sum of all PVs	Total PV	59,164
	Less: initial investment	20,000
Total PV - Initial investment	NPV	39,164

NPV will be highest with 100% bonus depreciation.

3). Since after-tax cash flows are decreased by 500 per year, it will impact the OCF directly.

PV of after-tax cash flows: PMT = 500; N = 4; rate = 11%, CPT PV.

PV = 1,551.22

NPV will reduce by the amount of 1,551

4). Since the sales price of 9,000 is foregone, it is an opportunity cost so the amount of initial investment should be increased by 9,000 to account for this.