Question

1. You graduated from Loyola two years ago, and you are now earning a salary of $50,000 per year. The total cost of your Loyola education was $200,000. You are now thinking about earning an MBA degree. Because of your excellent education at Loyola, you are eligible for the one-year, accelerated program at Global University, which has a cost of $120,000 for tuition, room, board, books, etc. To earn the MBA, you would have to quit your job and study full-time. As you are deciding what to do, your manager at work tells you that, based on your outstanding performance, you will be promoted in one month; the new position will carry a salary of $60,000 per year, or $10,000 more than you are earning now. You estimate that the MBA will translate into the following incremental after-tax earnings for the next ten years, which is your decision horizon:

       Incremental

Year                          After-tax Earnings

   1                                    $15,000

   2                                    20,000

   3                                    23,000

   4                                    26,000

   5                                    30,000

   6                                    35,000

   7                                    40,000

   8                                    50,000

   9                                    60,000

10                                    70,000

          You have a discount rate of 10.0%. Lastly, in order to get to/from class, you

          will need to spend more on transportation, and you will also have to eat

          several meals a week at fast food restaurants. These incremental net

          working capital costs will be $3,000 for the year. Your on-going fixed

overhead costs—for rent, clothes, insurance, food, etc.—are $20,000 per

year.

USING THE PRECEDING INFORMATION, PLEASE ANSWER THE

FOLLOWING QUESTIONS:

1. What is your

1. Sunk cost?
2. Fixed overhead cost?
3. Project cost?
4. Erosion?
5. Opportunity cost?
6. Incremental net working capital cost?

2. Combining all appropriate costs, what is the total cost of the MBA?
3. What is the present value of the incremental after-tax earnings?
4. What is the net present value of the MBA?
5. Should you pursue the MBA?
6. Should you factor in financing costs?
7. Should you factor in on-going fixed overhead costs?

Answer 1

Let's calculate NPV of the entire project considering discount factor of 10%

Particulars	Year 0	Year 1	Year 2	Year 3	Year 4	Year 5	Year 6	Year 7	Year 8	Year 9	Year 10	Total
Initial Investment	-120000	$    15,000	$    20,000	$    23,000	$    26,000	$    30,000	$    35,000	$    40,000	$    50,000	$    60,000	$    70,000
Incremental Working Capital		$     (3,000)	$    (3,000)	$    (3,000)	$    (3,000)	$    (3,000)	$    (3,000)	$    (3,000)	$    (3,000)	$    (3,000)	$    (3,000)
Ongoing fixed overhead cost		$   (20,000)	$ (20,000)	$ (20,000)	$ (20,000)	$ (20,000)	$ (20,000)	$ (20,000)	$ (20,000)	$ (20,000)	$ (20,000)
	$ (120,000)	$     (8,000)	$    (3,000)	$            -	$      3,000	$      7,000	$    12,000	$    17,000	$    27,000	$    37,000	$    47,000	19,000
Discount Rate	10%	10%	10%	10%	10%	10%	10%	10%	10%	10%	10%
DCF	1	$0.909	$0.826	$0.751	$0.683	$0.621	$0.564	$0.513	$0.467	$0.424	$0.386
NPV @ 10%	(120,000)	13,636	16,529	17,280	17,758	18,628	19,757	20,526	23,325	25,446	26,988	79,874

A

Sunk Cost - It's the cost of education of 200,000 $ in Loyola Education which is irrelevant to this choice of taking MBA.

Fixed Overhead Cost = (181,818) discounted NPV

Project Cost = Actual Education Cost + Erosion + Opportunity Cost

= 120,000 $ + 50,000 $ + 10,000 $

= 180,000 $

Erosion = 50,000 $ salary lost

Opportunity Cost = 10,000 $ incremental

Incremental Net working capital cost = (18,434) discounted NPV

B Present Value of Incremental After tax earnings

Net Present Value of MBA = 79,874 $

Should you pursue the MBA = Yes, since it results in positive cash flow NPV

Should you factor in financing costs = No, they shouldn't be considered for investment decision

Should you factor in ongoing fixed overhead costs - Overhead costs are not relevant in NPV and shouldn't be considered.