Question

Companies invest in expansion projects with the expectation of increasing the earnings of its business. Consider the case of Happy Dog Soap: Happy Dog Soap 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) 3,000 3,250 3,300 3,400 Sales price $17.25 $17.33 $17.45 $18.24 Variable cost per unit $8.88 $8.92 $9.03 $9.06 Fixed operating costs except depreciation $12,500 $13,000 $13,220 $13,250 Accelerated depreciation rate 33% 45% 15% 7%

This project will require an investment of $10,000 in new equipment. The equipment will have no salvage value at the end of the project’s four-year life. Happy Dog Soap pays a constant tax rate of 40%, and it has a required rate of return of 11%.

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.)

A.16,466

B.18502

C. 20,588

D.23,642

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.)

A. 25,485

B. 20,388

C. 23,466

D.19,369

Using the --------- depreciation method will result in the greater NPV for the project.

A. straight line

B. accelerated

The project will require an initial investment of $10,000, but the project will also be using a company-owned truck that is not currently being used. This truck could be sold for $14,000, after taxes, if the project is rejected. What should Happy Dog Soap do to take this information into account?

Increase the amount of the initial investment by $14,000.

Increase the NPV of the project by $14,000.

The company does not need to do anything with the value of the truck because the truck is a sunk cost.

Answer 1

NPV using Accelerated Depreciation

	Year 1	Year 2	Year 3	Year 4
Sales Price per unit	17.25	17.33	17.45	18.24
Variable Cost per unit	8.88	8.92	9.03	9.06
Contribution per unit	8.37	8.41	8.42	9.18
Number of units sold	3,000	3,250	3,300	3,400
Contribution Margin	25,110	27,333	27,786	31,212
Fixed Cost	12,500	13,000	13,220	13,250
Accelerated Depreciation Expenses	3,300	4,500	1,500	700
Earnings Before Tax	9,310	9,833	13,066	17,262
Tax at 40%	3,724	3,933	5,226	6,905
Earnings After Tax	5,586	5,900	7,840	10,357
Add: Depreciation Expenses	3,300	4,500	1,500	700
Annual Cash Inflow	8,886	10,400	9,340	11,057
Present Value Factor at 11%	0.90090	0.81162	0.73119	0.65873
Present Value of Annual Cash Inflows	8,005	8,440	6,829	7,284
Present Value of Annual Cash Inflows	$30,558
Less: Initial Investment	$10,000
Net Present Value	$20,558

“NPV using Accelerated Depreciation = (c)-$20,588”

NPV using Straight Line Depreciation

	Year 1	Year 2	Year 3	Year 4
Sales Price per unit	17.25	17.33	17.45	18.24
Variable Cost per unit	8.88	8.92	9.03	9.06
Contribution per unit	8.37	8.41	8.42	9.18
Number of units sold	3,000	3,250	3,300	3,400
Contribution Margin	25,110	27,333	27,786	31,212
Fixed Cost	12,500	13,000	13,220	13,250
Straight Line Depreciation Expenses	2,500	2,500	2,500	2,500
Earnings Before Tax	10,110	11,833	12,066	15,462
Tax at 40%	4,044	4,733	4,826	6,185
Earnings After Tax	6,066	7,100	7,240	9,277
Add: Depreciation Expenses	2,500	2,500	2,500	2,500
Annual Cash Inflow	8,566	9,600	9,740	11,777
Present Value Factor at 11%	0.90090	0.81162	0.73119	0.65873
Present Value of Annual Cash Inflows	7,717	7,791	7,122	7,758
Present Value of Annual Cash Inflows	$30,388
Less: Initial Investment	$10,000
Net Present Value	$20,388

“NPV using Straight Line Depreciation = (B). $20,388”

Using the “Accelerated” Depreciation method will result in the highest NPV for the Project

Happy Dog Soap should take the following information into account

Increase the amount of the initial investment by $14,000.