Question

Companies invest in expansion projects with the expectation of increasing the earnings of its business.

Consider the case of Garida Co.:

Garida Co. is considering an investment that will have the following sales, variable costs, and fixed operating costs:

	Year 1	Year 2	Year 3	Year 4
Unit sales	3,000	3,250	3,300	3,400
Sales price	$17.25	$17.33	$17.45	$18.24
Variable cost per unit	$8.88	$8.92	$9.03	$9.06
Fixed operating costs	$12,500	$13,000	$13,220	$13,250

This project will require an investment of $25,000 in new equipment. Under the new tax law, the equipment is eligible for 100% bonus deprecation at t = 0, so it will be fully depreciated at the time of purchase. The equipment will have no salvage value at the end of the project’s four-year life. Garida pays a constant tax rate of 25%, and it has a weighted average cost of capital (WACC) of 11%. Determine what the project’s net present value (NPV) would be under the new tax law.

1) Determine what the project’s net present value (NPV) would be under the new tax law.

$13,822

$12,286

$18,430

$15,358

2) Now determine what the project’s NPV would be when using straight-line depreciation. _________?   

Using the________________depreciation method will result in the highest NPV for the project. ?

3) No other firm would take on this project if Garida turns it down. How much should Garida reduce the NPV of this project if it discovered that this project would reduce one of its division’s net after-tax cash flows by $400 for each year of the four-year project?

$931

$745

$1,241

$1,365

4) The project will require an initial investment of $25,000, but the project will also be using a company-owned truck that is not currently being used. This truck could be sold for $9,000, after taxes, if the project is rejected. What should Garida do to take this information into account?

Increase the NPV of the project by $9,000.

Increase the amount of the initial investment by $9,000.

The company does not need to do anything with the value of the truck because the truck is a sunk cost.

Answer 1

Answer 1:

Computation of NPV = PV of Cash inflows - PV of cash outflows

	Particulars	Year 1	Year 2	Year 3	Year 4
A	Sales/unit	17.25	17.33	17.45	18.24
B	VC/unit	8.88	8.92	9.03	9.06
C= A - B	Contribution/unit	8.37	8.41	8.42	9.18
D	Units sold	3000	3250	3300	3400
E =C*D	Contribution	25110	27332.5	27786	31212
F	Fixed Operating Costs	12500	13000	13220	13250
G	Depriciation	25000	0	0	0
H=E-F-G	PBT	-12390	14332.5	14566	17962
I=H*0.25	Tax Expense / (Tax Savings) @ 25%	-3097.5	3583.125	3641.5	4490.5
J = H - I	PAT	-9292.5	10749.38	10924.5	13471.5
K	(+) Depriciation	25000	0	0	0
L = J + K	Cash Flows After Tax	15707.5	10749.38	10924.5	13471.5
M	PV of CFs factor @ 11%	0.900901	0.811622	0.731191	0.658731
N = L*M	PV of Cash Inflows for the year	14150.9	8724.434	7987.9	8874.094

NPV = 14150.90 + 8724.43 + 7987.90 + 8874.09 - 25000

= $ 14737

Answer 2 : Computation of NPV using straight Line method for Depirciation

	Particulars	Year 1	Year 2	Year 3	Year 4
A	Sales/unit	17.25	17.33	17.45	18.24
B	VC/unit	8.88	8.92	9.03	9.06
C= A - B	Contribution/unit	8.37	8.41	8.42	9.18
D	Units sold	3000	3250	3300	3400
E =C*D	Contribution	25110	27332.5	27786	31212
F	Fixed Operating Costs	12500	13000	13220	13250
G	Depriciation	6250	6250	6250	6250
H=E-F-G	PBT	6360	8082.5	8316	11712
I=H*0.25	Tax Expense / (Tax Savings) @ 25%	1590	2020.625	2079	2928
J = H - I	PAT	4770	6061.875	6237	8784
K	(+) Depriciation	6250	6250	6250	6250
L = J + K	Cash Flows After Tax	11020	12311.88	12487	15034
M	PV of CFs factor @ 11%	0.900901	0.811622	0.731191	0.658731
N = L*M	PV of Cash Inflows for the year	9927.928	9992.594	9130.387	9903.361

NPV = 9927.93 + 9992.59 + 9130.39 + 9903.36 - 25000

NPV = $ 13954

Using WDV method of depriciation, NPV would be higher.

Answer 3

Amount reduced should be present value of amounts

= 400*Present Value Annuity Factor (11%, 4)

= 400*3.10

= $ 1241

Answer 4

Amount of initial investment should be increased by $ 9000.