Question

1. 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% ?

please solve by formula method and not by excel method

Answer 1

Calculation of annual sales revenue and cost savings

	Year 1	Year 2	Year 3	Year 4
Revenue (5% annual growth)	$500 Million	$525 Million	$551.25 Million	$578.8125 Million
Project 1 Annual cost savings (15% of the annual revenue)	$75 million	$78.75 Milion	$82.6875 Million	$86.821875 Million
Project 2 Annual cost savings (12% of the annual revenue)	$60 Million	$63 Million	$66.15 Million	$69.4575 Million

Calculation of   net present value or PV of the cash flows Of PROJECT-1

(Amount in $ million)

	Year 1	Year 2	Year 3	Year 4
Annual cost savings	75	78.75	82.6875	86.821875
Less-Depreciation ($250 million/4 year)	(62.5)	(62.5)	(62.5)	(62.5)
Net cost savings after depreciation	12.5	16.25	20.1875	24.321875
Less-Income tax on Net cost savings@15%	1.875	2.4375	3.028125	3.64828125
After tax net savings	10.625	13.8125	17.159375	20.67359375
Add-Depreciation	62.5	62.5	62.5	62.5
Add-Salvage value of equipment after tax	--	---	---	42.5
Cash Flow	73.125	76.3125	79.659375	125.67359375

Year	Cash flows	PVF@10%	PV OF CASH FLOWS
0	-250	1	-250
1	73.125	0.9091	66.478
2	76.3125	0.8264	63.065
3	79.659375	0.7513	59.848
4	125.67359375	0.6830	85.835
		Total	$25.226 Million approx

Working Note-

Equipment salvage selling value = $50 million

Carrying amount at the end of 4th year = $ 0

Profit on sale = $50 Million-$0 =$50 million

tax = $50 million*15% = $7.5 Million

Net proceeds after tax = $50 Million-$7.5 Million= $42.5 Million

Calculation of   net present value or PV of the cash flows Of PROJECT-2

(Amount in $ million)

	Year 1	Year 2	Year 3	Year 4
Annual cost savings	60	63	66.15	69.4575
Less-Depreciation ($250 million/4 year)	(62.5)	(62.5)	(62.5)	(62.5)
Net cost savings after depreciation	-2.5	0.5	3.65	6.9575
Less-Income tax on Net cost savings@15%	0	0.075	0.5475	1.043625
After tax net savings	* =2.5*15% =0.375 tax savings	0.425	3.1025	5.913875
Add-Depreciation	62.5	62.5	62.5	62.5
Add-Salvage value of equipment after tax	--	---	---	85
Cash Flow	62.875	62.925	65.6025	153.413875

Year	Cash flows	PVF@10%	PV OF CASH FLOWS
0	-250	1	-250
1	62.875	0.9091	57.160
2	62.925	0.8264	52.001
3	65.6025	0.7513	49.287
4	153.413875	0.6830	104.782
		Total	$13.23 Million approx

*Note- Due to excess depreciation of $2.5 million there will be tax savings of $2.5*15% = $0.375 million. Becasue depreciation as an expenses will save tax.

Working Note-

Equipment salvage selling value = $100 million

Carrying amount at the end of 4th year = $ 0

Profit on sale = $100 Million-$0 =$100 million

tax = $100 million*15% = $15 Million

Net proceeds after tax = $100Million-$15 Million= $85 Million

conclusion -as the NPV of the Project 1 is more, hence project 1 is better.