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

The cashflows are calculated for 1st project as follows :

Project 1 (Amounts in Million $)
Year	0	1	2	3	4
Revenues		500.00	525.00	551.25	578.81
Cost Savings		75.00	78.75	82.69	86.82
Depreciation		-62.50	-62.50	-62.50	-62.50
Inremental EBT		12.50	16.25	20.19	24.32
Less Tax @15%		1.88	2.44	3.03	3.65
PAT		10.63	13.81	17.16	20.67
Add Depreciation		62.50	62.50	62.50	62.50
Capital Cost	-250
Post taxSalvage value					42.50
Cashflows	-250	73.13	76.31	79.66	125.67

NPV of project 1 = -250+ 73.13/1.1+76.31/1.1^2+79.66/1.1^3+125.67/1.1^4

=$25.23 million

The cashflows are calculated for 2nd Project as follows :

Project 2 (Amounts in Million $)
Year	0	1	2	3	4
Revenues		500.00	525.00	551.25	578.81
Cost Savings		60.00	63.00	66.15	69.46
Depreciation		-62.50	-62.50	-62.50	-62.50
Inremental EBT		-2.50	0.50	3.65	6.96
Less Tax @15%		-0.38	0.08	0.55	1.04
PAT		-2.13	0.43	3.10	5.91
Add Depreciation		62.50	62.50	62.50	62.50
Capital Cost	-250
Post taxSalvage value					85.00
Cashflows	-250	60.38	62.93	65.60	153.41

NPV of project 2 = -250+ 60.38/1.1+62.93/1.1^2+65.60/1.1^3+153.41/1.1^4

=$10.96 million

As the NPV of 1st Project is more than project 2,  Project 1 should be selected.