Question

An MNC IT company based in Germany, named IT AG, has identified two mutually exclusive cost saving projects. However, the equipment that will be required to realize the cost savings need an upfront investment of $250 million for both the projects. The annual cost savings expected from project 1 is 15% of the annual revenues and from project 2 is 12% of the annual revenues. The equipment used in both the projects have a useful life of 4 years. The firm has decided to employ a Straight Line Method (SLM) of depreciation and the ending period book value is zero for both the equipment. The firm expects to sell the equipment for projects 1 and 2 for $50 million and $100 million respectively at the end of 4 years. The year 1 revenue projected for this firm is $500 million, which is expected to grow at an annual growth rate of 5% for the subsequent years. The tax rate in Germany is 15%. Which project would you choose based on a discounting rate of 10% ?

Answer 1

Project 1
Year	0	1	2	3	4
Annual revenue = Revneue in Year 1*(1+g)^n g =growth rate = 5%		500	525	551.25	578.8125
cash outflow	-250
Annual cost savings-15% of revenue		75	78.75	82.6875	86.82188
less depreciation =250/4		62.5	62.5	62.5	62.5
operating profit		12.5	16.25	20.1875	24.32188
less taxes-15%		1.875	2.4375	3.028125	3.648281
after tax profit		10.625	13.8125	17.15938	20.67359
add depreciation		62.5	62.5	62.5	62.5
add after tax sale value = sale value*(1-tax rate) =50*(1-.15)					42.5
net operating cash flow	-250	73.125	76.3125	79.65938	125.6736
present value factor at 10% =1/(1+r)^n r=10%	1	0.909091	0.826446	0.751315	0.683013
present value of net operating cash flow = net operating cash flow*present value factor	-250	66.47727	63.06818	59.84927	85.83676
Net present value = sum of present value of net operating cash flow	25.23
Project 2
Year	0	1	2	3	4
Annual revenue = Revneue in Year 1*(1+g)^n g =growth rate = 5%		500	525	551.25	578.8125
cash outflow	-250
Annual cost savings-15% of revenue		60	63	66.15	69.4575
less depreciation =250/4		62.5	62.5	62.5	62.5
operating profit		-2.5	0.5	3.65	6.9575
less taxes-15%		-0.375	0.075	0.5475	1.043625
after tax profit		-2.125	0.425	3.1025	5.913875
add depreciation		62.5	62.5	62.5	62.5
add after tax sale value = sale value*(1-tax rate) =50*(1-.15)					85
net operating cash flow	-250	60.375	62.925	65.6025	153.4139
present value factor at 10% =1/(1+r)^n r=10%	1	0.909091	0.826446	0.751315	0.683013
present value of net operating cash flow = net operating cash flow*present value factor	-250	54.88636	52.00413	49.28813	104.7837
Net present value = sum of present value of net operating cash flow	10.96
Project 1 is better in comparison to project 2 As it results in greater NPV in comparison of NPV of project 2