Question

5. Exercise 17.5 The Charlotte Bobcats, a professional basketball team, has been offered the opportunity to purchase the contract of an aging superstar basketball player from another team. The general manager of the Bobcats wants to analyze the offer as a capital budgeting problem. The Bobcats would have to pay the other team $800,000 to obtain the superstar. Being somewhat old, the basketball player is expected to be able to play for only four more years. The general manager figures that attendance, and hence revenues, would increase substantially if the Bobcats obtained the superstar. He estimates that incremental returns (additional ticket revenues less the superstar’s salary) would be as follows over the four-year period:

Year	Incremental returns ($)	Net Cash Flow($)	Interest Factor at 12%	Present Value (PV) ($)
1	$ 450,000	$	0.89286	$
2	$350,000	$	0.79719	$
3	$275,000	$	0.71178	$
4	$200,000	$	0.63552	$
			Total Present Value	$

The general manager has been told by the owners of the team that any capital expenditures must yield at least 12 percent after taxes. The firm’s (marginal) income tax rate is 40 percent. Furthermore, a check of the tax regulations indicates that the team can depreciate the $800,000 initial expenditure over the four-year period.

a) Complete the preceding table to compute the total present value, discounted at the firm’s cost of capital, of the stream of net cash flows from the investment.

b) What is the net present value (NPV) of cash flows for this investment? ( --Answer------------)

c) Should the Bobcats sign the superstar?

No

Yes

Answer 1

Year	Incremental returns ($)	Net Cash Flow($)	Interest Factor at 12%	Present Value (PV) ($)
1	$450,000	$350,000.0	0.89286	$312,501.0
2	$350,000	$290,000.0	0.79719	$231,185.1
3	$275,000	$245,000.0	0.71178	$174,386.1
4	$200,000	$200,000.0	0.63552	$127,104.0
			Total Present Value	$845,176.2

Ans A)

Net Cash Flow is nothing but the after tax cash flow

tax rate is 40% and we are going to depreciate $800,000 each year over the course of 4 years as $200,000 each hence we would get the tax shield

For an example In year 1 Incremental returns=$450,000
Depreciation would be $200,000

We would deduct this depreciation from Incremental return =450000-200000=250,000

Resulting taxes paid=250000*0.4=100,000

Net Cash Flow=450,000-100,000=350,000

Similarly for year 2

Net Cash flow=350000*0.6+Tax Shield=350000*0.6+200000*0.4=290,000

for year 3

Net Cash flow= 275000*0.6+200000*0.4=245,000

for year 4
Net Cash flow=200000*0.6+2000000*0.4=200,000

Ans B)

Present Value of Net Cash flow for year 1=350000* interest factor for year 1=350000*0.89286=312501

Similarly we can calculate PV for each year

And then sum up all PV to get Total Present Value=$845,176.2

Now Net Present Value=Total Present Value of Net Cash flow-Initial Cost
=845176.2-800000=$45176.2>0

Net Present Value=$45176.2

Ans C)

Hence Bobcats can sign Superstar. Answer is Yes