Question

In: Finance

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

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.

Solutions

Expert Solution

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.


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