Question

In problems where no equity risk premium or tax rate are provided, please use an equity risk premium of 5.5% and a tax rate of 40%.

1. You have been given the following information on a project:

• It has a five-year lifetime

• The initial investment in the project will be $25 million,

Year  % of Depreciable Asset

1         40

2         20

3         14.4

4          13.3

5          13.3

• The revenues are expected to be $20 million next year and to grow 10% a year after that for the remaining four years.

• The cost of goods sold, excluding depreciation, is expected to be 50% of revenues.

• The tax rate is 40%.

1. Estimate the pretax return on capital by year and on average, for the project.

b. Estimate the after-tax return on capital, by year and on average, for the project.

c. If the firm faced a cost of capital of 12%, should it take this project?

Answer 1

Year	Revenue	Cost of goods sold (50%of revenue )	Net	Depreciation	Net after depreciation	Tax @40%	After tax	Cash Flow after tax	Return pre tax	Return after tax
1	20.00	10.00	10.00	10.00	-	-	-	10.00	0.00%	0.00%
2	22.00	11.00	11.00	5.00	6.00	2.40	3.60	8.60	24.00%	14.40%
3	24.20	12.10	12.10	3.60	8.50	3.40	5.10	8.70	34.00%	20.40%
4	26.62	13.31	13.31	3.33	9.99	3.99	5.99	9.32	39.94%	23.96%
5	29.28	14.64	14.64	3.08	11.57	4.63	6.94	10.01	46.26%	27.76%
								Average	28.84%	17.30%
	Year	Cash Flow after tax	Discounting rate	PV
	1	10.00	0.89	8.93
	2	8.60	0.80	6.86
	3	8.70	0.71	6.19
	4	9.32	0.64	5.92
	5	10.01	0.57	5.68
			Total	33.58
			Investment	25
			NPV	8.58