Question

Assume you have completed a capital budgeting analysis of building a new plant on land you own, and the project's NPV is $100 million. You now realize that instead of building the plant, you could build a parking garage, and would generate a pre tax revenue of $15 million. The project would last 3 years, the corporate tax rate is 40%, and the WACC is 7%. What is the new NPV of the project, after incorporating the effect of the opportunity cost?

Answer 1

Project's current NPV = $100 million

Instead of building plant, if one builds garage then pre tax revenue generated by garage = $15 million

Opportunity cost represents revenue forgone as a result of selecting the current project. In this question after tax revenue from parking garage represents opportunity cost of the project. NPV of the project after incorporating the effect of opportunity cost can be found out by subtracting present value of after tax opportunity cost from current NPV of the project

After tax revenue from parking garage = pre tax revenue generated by garage(1-tax rate) = 15(1-40%) = 15 x 60% = 9 million

Present value of after tax opportunity cost discounted at WACC = 9 / (1+7%) + 9 / (1+7%)² + 9 / (1+7%)³ = 8.4112 + 7.8609 + 7.3466 = 23.6187

NPV of the project adjusted for opportunity cost = Current NPV - Present value of after tax opportunity cost = 100 - 23.6187 = 76.3813 = 76.38 (rounded to two decimal places)

Hence NPV of the project adjusted for opportunity cost = $76.38