Question

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

Consider the case of Celestial Crane Cosmetics:

Celestial Crane Cosmetics 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 (units)	4,800	5,100	5,000	5,120
Sales price	$22.33	$23.45	$23.85	$24.45
Variable cost per unit	$9.45	$10.85	$11.95	$12.00
Fixed operating costs except depreciation	$32,500	$33,450	$34,950	$34,875
Accelerated depreciation rate	33%	45%	15%	7%

This project will require an investment of $25,000 in new equipment. The equipment will have no salvage value at the end of the project’s four-year life. Celestial Crane Cosmetics pays a constant tax rate of 40%, and it has a required rate of return of 11%.

1.)   When using accelerated depreciation, the project’s net present value (NPV) is ________ . (Hint: Round each element in your computation—including the project’s net present value—to the nearest whole dollar.)

2.)   When using straight-line depreciation, the project’s NPV is _______ . (Hint: Again, round each element in your computation—including the project’s net present value—to the nearest whole dollar.)

3.)   Using the ____________ (straight line/accelerated) depreciation method will result in the greater NPV for the project.

4.)   No other firm would take on this project if Celestial Crane Cosmetics turns it down. How much should Celestial Crane Cosmetics 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 $700 for each year of the four-year project?

a.) $2,172

b.) $1,303

c.) $1,846

d.) $1,629

5.)   Celestial Crane Cosmetics spent $2,750.00 on a marketing study to estimate the number of units that it can sell each year. What should Celestial Crane Cosmetics do to take this information into account?

a.) The company does not need to do anything with the cost of the marketing study because the marketing study is a sunk cost.

b.) Increase the amount of the initial investment by $2,750.00.

c.)   Increase the NPV of the project $2,750.00.

Answer 1

1.

To calculated NPV, net cash flows must first be calculated for each of the four years. Cash flows can be calculated as the net income after taxes plus the depreciation amount. Net income is calculated simply as Sales - variable costs - fixed costs - depreciation - income taxes. This calculation is shown in the table below:

Note that depreciation is first deducted and then added back in order to incorporate for the effect of depreciation tax shield. Depreciation acts as a tax shield by reducing the amount of taxes, a company needs to pay even thought there is no real cash outflow that is happening.

Now, these cash flows, along with the initial investment of 25,000 can be used to calculate the net present value using a discount rate of 11%. Calculations are as shown below:

So, when using accelerated depreciation, NPV of the given project is 36,218.

2.

Method for this part remains the same, just the depreciation figure used to calculate net cash flow changes. The depreciation amount can be calculated as initial investment - salvage value whole divided by the duration of project or 25,000/4 = 6250. Cash flow and NPV calculations are as shown below:

So, using straight line depreciation, NPV comes out to be 35791

3.

Accelerated depreciation, as can be seen from the above results.

4.

NPV of the project should be reduced by the present value of a $700 cash flow from year 1 through 4, at a discount rate of 11%. The cash flow and its NPV calculation are as shown:

So, the answer is a) 2172

5.

The answer is a) The company does not need to do anything with the cost of the marketing study because the marketing study is a sunk cost.

This is because while calculating NPV, only future cash flows and costs need to be considered. Costs that have already been incurred do not add any value to the NPV analysis, as they have already happened.