Question

You are considering opening a drive-in movie theater and running it for ten years. You have spent after-tax $10,000 researching the land that will be used for theater, but if you take the project you expect to incur another immediate after-tax expense of $20,000 as you work with a consulting firm to decide how to most efficiently run the business.

The project entails an immediate $100,000 capital expenditure, which can be depreciated over 10 years. You expect to sell this capital investment for $25,000 at the end of the ten year project. Working capital expenses for the project are $50,000 immediately, $40,000 incurred two years from today, both of which are fully recovered in ten years (at the end of the project).

The project’s operating costs are expected to be $100,000 for each of the first five years and then (starting between t=5 and t=6) grow at -5% per year through the end of the project (i.e., through t=10). You expect the project’s revenues to start at $100,000 starting one year from today and remain constant for the life of the project.

1. ) You decide to use 10% as the project’s opportunity cost of capital. Your expected tax rate is 25%. What is the project’s NPV?

Answer 1

CALCULATION OF DEPRECIATION :
Annual Depreciation = (Initial Purchase Cost – Salvage Value) / No of Years
                                      = (100,000 – 25,000) /10
                                      = 75,000/10
                                         = $7,500
                                     
Operating Expenses after 5 years are calculated as :
OE6 = OE5 * (1-.05)
OE7 = OE6 * (1-.05)
OE8 = OE7 * (1-.05)
OE9 = OE8 * (1-.05)
OE10 = OE9 * (1-.05)

$10,000 spend on researching the land forms a part of sunk cost. Hence the same has been avoided while doing the calculations.