Question

Your firm is considering a fast-food concession at the World's Fair in College Station. The cash flow pattern is somewhat unusual because you must build the stands, operate them for 2 years, and then tear the stands down at the     end of the third year to restore the sites to their original condition (the stand sits idle for one year). Your firm requires a 15% pre-tax return on capital. Your firm anticipates having a marginal tax rate of 20% for the next three years. The IRS will allow your firm to depreciate the initial cost of the investment over two years. The cost of tearing down the booth is considered a tax deductible expense. You estimate that it will cost $900,000 to build and $200,000 to tear down at the end of the third year (assume the terminal value and after-tax terminal value are zero and treat the tear-down cost as an expense at the end of the third year). Your revenues will be $850,000 and operating expenses will be $200,000 at the end of each of the first two years from operating the concession stand.

1. What is the present value of after-tax net returns?

A. $900,000

B. $764,941

C. $17,046

D. $152,104

E. $0

F. None of the above

2. What is the present value of the tax savings from depreciation?

A. $900,000

B. $764,941

C. $17,046

D. $152,104

E. $0

F. None of the above

3. What is the present value of the after-tax terminal?

A. $900,000

B. $764,941

C. $17,046

D. $152,104

E. $0

F. None of the above

4. What is the Net Present Value?

A. $900,000

B. $764,941

C. $17,046

D. $152,104

E. $0

F. None of the above

Answer 1

	Year 1	Year 2	Year 3
Revenues	$8,50,000.00	$8,50,000.00	$0.00
(-) Operating expenses	$2,00,000.00	$2,00,000.00	$0.00
Operating profit	$6,50,000.00	$6,50,000.00	$0.00
(-) Tearing down cost	$0.00	$0.00	$2,00,000.00
(-) Depreciation (900000/2)	$4,50,000.00	$4,50,000.00	$0.00
Profit before tax	$2,00,000.00	$2,00,000.00	-$2,00,000.00
(-) Taxes @ 20%	$40,000.00	$40,000.00	-$40,000.00
Profit after taxes	$1,60,000.00	$1,60,000.00	-$1,60,000.00
(+) Depreciation	$4,50,000.00	$4,50,000.00	$0.00
Cash flows	$6,10,000.00	$6,10,000.00	-$1,60,000.00
After tax cost of capital 15%*(1-0.20)	12%	12%	12%
Present value factor 1/(1+12%)^n, n=1,2,3	0.89	0.80	0.71
Present values of cash flows (Cash flows * Present value factor)	$5,44,642.86	$4,86,288.27	-$1,13,884.84

1. Present value of after tax returns = Sum of present values of cash flows – Initial investment

                                                         = $544,642.86 + $486,288.27 - $113,884.84 - $900,000

                                                         = $17,046.

Hence, option C is correct.

2. Present value of tax savings from depreciation is computed as below:

$450,000 * 0.89 * 20% + $450,000 * 0.80 * 20% = $152,104. (As tax rate is 20%)

Hence, option D is correct.

3. As the after tax terminal value is 0 (given in the problem), the present value of after tax terminal would also be 0.

Hence, option E is correct.

4. NPV= Sum of present values of cash flows – Initial investment

            = $544,642.86 + $486,288.27 - $113,884.84 - $900,000

            = $17,046.

Hence, option C is correct.