Question

Capital Budgeting

1.      The PolyGram Firm is considering expanding its production line to satisfy the demand for more CDs. The firm has commissioned consultant studies for the expansion, spending $200,000 for these studies. The results of the studies indicate that the firm must spend $1 million on a new building and $500,000 on production equipment. The consultants’ report predicts that the firm can increase its revenues by $400,000 each year, while incurring an increase of $160,000 in expenses. The consultants expect rivals to step up production within five years, reducing benefits from the expansion to PolyGram after five years. There­fore, a 5-year time horizon is assumed for this expansion project. The expansion would require that the firm increase it cur­rents assets by $100,000 initially, but these asset accounts will be returned to previous levels at the end of the project.

Assume that the building is depreciated using straight-line over a 20-year period and that it can be sold at the end of five years for $800,000. Further assume that the equipment is depre­ciated using straight-line over a 10-year period and that it can be sold at the end of five years for $150,000. The marginal tax rate of PolyGramis 40%. The cost of capital for this project is 10%. Should PolyGram invest in this project? Explain.

Answer 1

NPV is negative, so PolyGram should not invest in the project.

Depreciation of the building will be over 20 years, = 1,000,000 / 20 = $50,000 per year

Dpereciaiton of the equipment will be over 10 years = 500,000 / 10 = $50,000 per year

Depreciation will be added back to net income to get Operating income

Investments and change in net working capital will be added to operating income to get Free cash flow

Salvage value of building at year 5 = $800,000

Book value of building at year 5 = Initial purchase price - accumulated depreciation = 1,000,000 - 250,000 = $750,000

After tax salvage value of building = Salvage value - Tax rate x (Salvage value - book value) = 800,000 - 0.4 x (800,000 - 750,000) = 800,000 - 20,000 = $780,000

Salvage value of equipment at year 5 = $150,000

Book value of equipment at year 5 = 500,000 - 250,000 = $250,000

After tax salvage value of equipment = 150,000 - 0.4 x (150,000 - 250,000) = 150,000 + 40,000 = $190,000