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

For project 1, Cost Savings = 15% * revenue

For project 2, Cost Savings = 12% * revenue

Tax = Cost savings * 15%

Add back depreciation to calculate net cash flow.

Depreciation = Investment / no. of useful life

Comparing the NPV of both the projects, Project 1 has higher NPV than Project 2. Choose Project 1.