Question

British Columbia Research Associates Incorporated (BCRA), a dynamic and thriving research company, has an opportunity to land a lucrative federal government contract in which they would analyze census data. The project would last four years. BCRA has already spent $150,000 lobbying the appropriate people in the Department of Vital Statistics as well as the Minister in charge of the Department in order to try to land this contract. The project would start on January 1, 2021. BCRA currently owns the building where it conducts its other research activities. However, some of the office space in the building is unoccupied. BCRA intends to lease the unused office space to the British Columbia Department of Agriculture for four years starting January 1, 2021. The expected lease payments would be $10,000 per year payable at the start of each year. If the census project is accepted, BCRA would have to forego the lease as it would have to use the unoccupied office space in order to analyze the census data. Assume for convenience that all “up-front” costs of the project (office space improvements, furnishings, computers, etc.) will total $250,000 and that all the new assets will be placed in a CCA class with a rate of 25%. At the end of the project, BCRA believes that it can dispose of these new assets for $75,000. Since BCRA has many assets in this CCA class, neither terminal loss nor recaptured depreciation will be an issue. The contract would result in revenues of $175,000 in the first year of the project, and to combat inflation, these revenues would grow at 2% per year for the remaining years of the project. Incremental expenses associated with the project are projected to be $60,000 in the first year of the project and are projected to decline at 2% for the remainder of the project as operational efficiencies occur. Although additional employees will be hired, it is expected that some of BCRA’s “regular” staff will have to put in overtime. It is expected that this overtime cost will be $25,000 per year for the duration of the project. Assume that all these cash flows occur at the end of each year of the project. You are a recent new employee in the finance department of BCRA, and you have been given the task of determining if the contract should be accepted. Naturally, your future with the company is highly dependent on your recommendation. You have been informed that BCRA’s tax rate is 35% and that the cost of capital to be applied to projects such as this is 12%. Perform an NPV analysis to determine if the company should accept or reject the proposed contract. Solution (show all your work): i) Sunk Costs: ii) Initial Investment: iii) Opportunity Costs: iv) Incremental Revenues: v) Incremental Expenses: vi) PV of CCA tax shield: vii) PV of salvage: viii) Side effects: ix) NPV: x) Should the project be rejected or not, and why (two to three lines, maximum)?

Answer 1

Since BCRA has already spent $1,50,000 the same is sunk cost since the acceptance or rejection of the project is not imapcted with this amount as it has already been spent. Same will not be considered in NPV calculations for the project.

Depreciation
	Opening WDV	Depreciation	closing WDV
Year-1	250000	62500	187500
Year-2	187500	46875	140625
Year-3	140625	35156.25	105469
Year-4	105468.75	26367.1875	79102

	Year - 0	Year - 1	Year - 2	Year - 3	Year - 4
Initial investment	-250000
Incremental revenue (2% inflation from year - 2)		175000	178500	182070	185711.4
Incremental expense (2% decline from year-2)		60000	58800	57624	56471.52
Opportunity cost		10000	10000	10000	10000
Depreciation		62500	46875	35156	26367
Side effects(overtime)		25000	25000	25000	25000
Earnings before tax	-250000	17500	37825	54290	67872.88
Tax @ 35%		6125	13239	19001.5	23755.51
Earnings after tax		11375	24586	35288.5	44117.37
Salvage value					75000
Net cash flows		11375	24586	35288.5	119117.4
Present value factor @ 12% (1/(1+r)^n)		0.8928	0.7972	0.7118	0.6355
Present value of cash flow for each year	-250000	10155.6	19600	25118.35	75699.09	-119427

Since the NPV of the project is negative, the project is supposed to be rejected. Instead, it can rent the excess unutlised space for rent.