Question

Companies invest in expansion projects with the expectation of increasing the earnings of its business.

Consider the case of Garida Co.:

Garida 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	3,500	4,000	4,200	4,250
Sales price	$38.50	$39.88	$40.15	$41.55
Variable cost per unit	$22.34	$22.85	$23.67	$23.87
Fixed operating costs	$37,000	$37,500	$38,120	$39,560

This project will require an investment of $25,000 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. Garida 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.

$47,736

$54,896

$38,189

$57,283

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 Garida turns it down. How much should Garida 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 $300 for each year of the four-year project?

$1,024

$931

$791

$559

Garida spent $2,750 on a marketing study to estimate the number of units that it can sell each year. What should Garida do to take this information into account?

A) Increase the amount of the initial investment by $2,750.

B) The company does not need to do anything with the cost of the marketing study because the marketing study is a sunk cost.

C) Increase the NPV of the project $2,750.

Answer 1

1. NPV under New Tax Law = $47736

2. NPV under Straight Line Depreciation = $46334

3. Using the New Tax Law depreciation method will result in the highest NPV for the project.

4. Reduction in NPV = Annual Cash Inflows * PVAF (0.11,4)

Reduction in NPV = 300 * 3.1024

Reduction in NPV = $931

5. Option B

B) The company does not need to do anything with the cost of the marketing study because the marketing study is a sunk cost. The expenses incurred for research and market study are all sunk cost and are not required while computing NPV