Question

a) A manager of a firm in the area of Dukagjini region is considering to knocking down the old barn to provide much needed parking space for tractors and equipment. This project would require an immediate expense of £110,000 to remove the asbestos and to knock down the barn. Building the car park would then cost £17,000. The space created would have spare capacity, which will be rented out at £45,000 (pre-tax) per year for parking and other uses. This project also lasts five years and has no residual value at the end. The farmer is able to depreciate the total cost of removing the asbestos, knocking down the building and building the car park. This is done over the five years of the project using the straight-line method. The corporate tax rate is 28%. The nominal discount rate is 3% and all cash flows are nominal values. . At the moment the farmer is paying £3,000 per year (post-tax) to park these on a neighbour’s land.

Calculate the net present value of this project.

b) An alternative is to expand its production capacities. The only possible location is an old barn owned by the farm but not utilised because of asbestos contamination. For legal reasons the building cannot be sold or leased. At a cost of £2,000, the farmer hired an environmental expert, who produced a report with detailed plans for the removal of the asbestos in compliance with environmental regulations. To refurbish the barn—including removing the chemical substances it is expected to cost £350,000. The cheesemaking equipment costs £150,000. Starting at the end of year one, cheese production is expected to yield £170,000 yearly for five years in pre-tax revenue minus cash expenses. The firm depreciates the refurbishment cost and the cost of the cheese-making equipment over the five years of the project using the straight-line method. There is no residual value at the end of the project. The corporate tax rate is 28%. The nominal discount rate is 7% and all values are nominal values.

Calculate the net present value of this project.

c) The farmer asks for your advice on how to choose between the two projects using the information in Parts (a) and (b. What would be your advice to the farmer? Explain.

d) Why might it be appropriate to use different discount rates for different projects, such as those in Parts (a) and (b)? Briefly explain.

Answer 1

Facts given in project 1
Immediate expense to remove the asbestos and to knock down the barn (A)	£ 1,10,000.00
Building the car park (B)	£    17,000.00
Saving in parking cost p.a. (post tax)	£      3,000.00
Rental income pretax p.a.	£    45,000.00
Discount rate	3%
Tax rate	28%
Project life	5 years
Residual value	0
Calculations	Amount	Present value	Remarks
Total cost incurred on Day 0 (A+B)	£ 1,27,000.00	-£1,27,000.00
Depreciation p.a. for 5 years under straight line method (127000/5)	£    25,400.00
Corporate tax savings on account of depreciation (25400*28%)	£      7,112.00	₹ 32,570.88	Discounted cashflow = CF1/(1+r)^1 + CF2/(1+r)^2 + CFn/(1+r)^n i.e. (7112/(1+0.03)^1)+(7112/(1+0.03)^2)+(7112/(1+0.03)^3)+(7112/(1+0.03)^4)+(7112/(1+0.03)^5)
Savings in parking cost p.a. (post tax)	£      3,000.00	₹ 13,739.12	Discounted cashflow = CF1/(1+r)^1 + CF2/(1+r)^2 + CFn/(1+r)^n i.e. (3000/(1+0.03)^1)+(3000/(1+0.03)^2)+(3000/(1+0.03)^3)+(3000/(1+0.03)^4)+(3000/(1+0.03)^5)
Rental income post tax p.a. (45000*(100%-28% tax))	£    32,400.00	₹ 1,48,382.51	Discounted cashflow = CF1/(1+r)^1 + CF2/(1+r)^2 + CFn/(1+r)^n i.e. (32400/(1+0.03)^1)+(32400/(1+0.03)^2)+(32400/(1+0.03)^3)+(32400/(1+0.03)^4)+(32400/(1+0.03)^5)
Total present value		£    67,692.51
Facts given in project 2
Environmental expert cost	£      2,000.00
Cost for refurbishment of barn (A)	£ 3,50,000.00
Cheesemaking equipment cost (B)	£ 1,50,000.00
Pre tax revenue from Cheese production starting from end of year 1	£ 1,70,000.00
Discount rate	7%
Tax rate	28%
Project life	5 years
Residual value	0
Calculations	Amount	Present value	Remarks
Total cost incurred on Day 0 (A+B)	£ 5,00,000.00	-£5,00,000.00
Depreciation p.a. for 5 years under straight line method (500000/5)	£ 1,00,000.00
Corporate tax savings on account of depreciation (100000*28%)	£    28,000.00	₹ 1,14,805.53	Discounted cashflow = CF1/(1+r)^1 + CF2/(1+r)^2 + CFn/(1+r)^n i.e. (28000/(1+0.07)^1)+(28000/(1+0.07)^2)+(28000/(1+0.07)^3)+(28000/(1+0.07)^4)+(28000/(1+0.07)^5)
Parking cost p.a.	£      3,000.00	₹ -12,300.59	Discounted cashflow = CF1/(1+r)^1 + CF2/(1+r)^2 + CFn/(1+r)^n i.e. (3000/(1+0.07)^1)+(3000/(1+0.07)^2)+(3000/(1+0.07)^3)+(3000/(1+0.07)^4)+(3000/(1+0.07)^5)
Cheese production revenue post tax (170000*(100%-28% tax))	£ 1,22,400.00	₹ 5,01,864.17	Discounted cashflow = CF1/(1+r)^1 + CF2/(1+r)^2 + CFn/(1+r)^n i.e. (122400/(1+0.07)^1)+(122400/(1+0.07)^2)+(122400/(1+0.07)^3)+(122400/(1+0.07)^4)+(122400/(1+0.07)^5)
Net present value		£ 1,04,369.10
Note that environment expert cost is not deducted since it will be common expenditure

Answer for question C: Hence project B is better since net present value is higher for project b as compared to project a

Answer for question D: It might be justifiable to use different discount rates for both projects because of higher capital requirement in project  B and risk of investment