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

Depreciation = Historical cost / useful life = 250/4 = 62.5 million

Project 1

Particulars	1	2	3	4	Total
a	Revenue	500	525	551.25	578.8125
b= a*15%	Cost Saving	75	78.75	82.6875	86.82188
c=b*15%	Tax on cost savings	11.25	11.8125	12.40313	13.02328
d=b-c	After tax csot savings	63.75	66.9375	70.28438	73.79859
e=62.5*15%	Depreciation Tax shield	9.375	9.375	9.375	9.375
f= d+e	Cash flows	73.125	76.3125	79.65938	83.17359
g	Discounting factor = 1 /( 1+r)^n	0.909091	0.826446	0.751315	0.683013
h=f*g	Present value of cash flows	66.47727	63.06818	59.84927	56.80868	246.2034057
i	After tax value of sale of equipment =50*(1 -0.15)	42.5
j	Present value of after tax value of equipment = 42.50/1.1^4	29.02807185
k	Initial Investment	250
l	Net Present Value = sum of presnet value of cash inflows + after tax value of equipment - initial investment	25.23147753

Project 2

Particulars	1	2	3	4	Total
a	Revenue	500	525	551.25	578.8125
b= a*12%	Cost Saving	60	63	66.15	69.4575
c=b*15%	Tax on cost savings	9	9.45	9.9225	10.41863
d=b-c	After tax cost savings	51	53.55	56.2275	59.03888
e=62.5*15%	Depreciation Tax shield	9.375	9.375	9.375	9.375
f= d+e	Cash flows	60.375	62.925	65.6025	68.41388
g	Discounting factor = 1 /( 1+r)^n	0.909091	0.826446	0.751315	0.683013
h=f*g	Present value of cash flows	54.88636	52.00413	49.28813	46.7276	202.9062223
i	After tax value of sale of equipment =100*(1 -0.15)	85
j	Present value of after tax value of equipment = 85/1.1^4	58.05614371
k	Initial Investment	250
l	Net Present Value = sum of presnet value of cash inflows + after tax value of equipment - initial investment	10.96236596

We will choose Project 1 as the NPV is higher for Project 1 then Project 2