Question

In: Accounting

An MNC IT company based in Germany, named IT AG, has identified two mutually exclusive cost...

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% ?

Solutions

Expert Solution

Projected Revenue (Amount in millions)

Year 1 2 3 4
Projected Revenue $500 $525 $551.25 $578.8125

Net Cash Savings after Tax

Project 1:(Amount in millions)

Year 1 Year 2 Year 3 Year 4
Annual Cost Savings $75 $78.75 $82.6875 $86.8219
Less: Depreciation $62.50 $62.50 $62.50 $62.50
Net Savings $12.50 $16.25 $20.1875 $24.3219
Less: Taxes $1.875 $2.4375 $3.0281 $3.6483
Savings after Tax $10.625 $13.8125 $17.1594 $20.6736
Add: Depreciation $62.50 $62.50 $62.50 $62.50
Net Cash Savings after Tax $73.125 $76.3125 $79.6594 $83.1736

Project 2:(Amount in millions)

Year 1 Year 2 Year 3 Year 4
Annual Cost Savings $60 $63 $66.15 $69.4575
Less: Depreciation $62.50 $62.50 $62.50 $62.50
Net Savings $(2.50) $0.50 $3.65 $6.9575
Less: Taxes $0.375 $0.075 $0.5475 $1.0436
Savings after Tax $(2.125) $0.425 $3.1025 $5.9139
Add: Depreciation $62.50 $62.50 $62.50 $62.50
Net Cash Savings after Tax $60.375 $62.925 $65.6025 $68.4139

Net Present Value of both the Projects:

Project 1:(Amount in millions)

Year Cash Flow after Tax DF @ 10% Present Value
1 73.125 0.9091 66.4779
2 76.3125 0.8264 63.0647
3 79.6594 0.7513 59.8481
4 83.1736 0.6830 56.8076
4 42.50 (50*0.85) 0.6830 29.0275
TOTAL 275.2258
Less: Initial Outlay 250
Net Present Value $25.2258

Project 2:(Amount in millions)

Year Cash Flow after Tax DF @ 10% Present Value
1 60.375 0.9091 54.8869
2 62.925 0.8264 52.0012
3 65.6025 0.7513 49.2872
4 68.4139 0.6830 46.7267
4 85 {100*0.85} 0.6830 58.055
TOTAL 260.9570
Less: Initial Outlay 250
Net Present Value $10.9570

Hence Project 1 should be selected since it has a higher net present value of $25.2258 million as compared to Project 2 which has a net present value of $10.9570 million.


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