Question

Prob 1: Do not work on problem 1. I would you to work on problem 2

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, and the investment will be depreciated straight line, down to a salvage value of $10 million at the end of the fifth year.

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%.

Estimate the pretax return on capital, by year and

on average, for the project.

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

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

Prob 2:

Now assume that the facts in Problem 1 remain un- changed except for the depreciation method, which is switched to an accelerated method with the following de- preciation schedule:

Year % of Depreciable Asset

1 40

2 20

3 14.4

4 13.3

5 13.3

Depreciable asset = Initial investment − Salvage value

Estimate the pretax return on capital, by year and

on average, for the project.

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

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

Answer 1

Depreciable Value

Depreciation

Pre tax and After Tax Return on capital

Calculation of Annual Cash Flows

Calculation of Net Present Value

Present Value = Cash Flow / ( [100+Required return]%^Year )

Required Return = 12%

Annual Cash Flows Calculated above.

Find the values here:

There is a positive Net Present Value of $11.19 million using required rate of 12%. Hence,the firm should take this project.