Question

XYZ Company’s current equipment, a Neon 89-H, can be sold today for $1,000,000 net. A brand-new Neon 89-H for almost $3,250,000; however, Megan believes she can purchase it for $3,000,000 today. She will fund this purchase in part with proceeds from the sale of the Neon 89-H. In addition, accounts payable are expected to increase by $1,500,000 today, and fully reverse in year 4.

The new equipment will be in operation beginning in year two. As the old equipment will be offline in year 1, Megan forecasts lost revenues of $550,000 in year 1 arising from the idled equipment. The cost savings in years 2, 3 and 4 are estimated at $600,000, $950,000, and $1,000,000, respectively. XYZ Company’s cost of capital and tax-rate remain unchanged. The equipment is depreciated using straight line depreciation (i.e., Equipment Cost – Salvage Value) / Useful Life). Megan assumes the equipment will be worth $5.00 after four years.

The CEO is concerned that the estimated cost of capital for XYZ Co. is too high. He adjusts XYZ’s Beta and computes a new cost of capital of 5 percent. Using this, what is this project’s NPV?

Risk-Free Rate (10-Year U.S. Treasury) = 3%

The Equity Risk Premium = 4.5%

Tax Rate: 40%

beta (β) = 1.2

Market Value of Equity / Total Capital ratio = 100%

Market Value of Debt / Total Capital = 0%

Answer 1