Question

Management of Group A Corporation is considering an expansion in the company’s product line that requires the purchase of an additional $200,000 in equipment with installation cost of $20,000 and removal expense of $5,000. The equipment and installation costs will be depreciated over five years using straight-line depreciation method. The expansion is expected to increase earnings before depreciation and taxes as follows:

Expected Worst Best

Year 1 $75,000 $50,000 $100,000

Year 2 $ 75,000 $60,000 $100,000

Year 3 $90,000 $75,000 $120,000

Year 4 $90,000 $75,000   $120,000

Year 5 $60,000 $45,000 $ 75,000

Group A Corporation’s income tax rate is 30 percent, and the weighted average cost of capital is 10 percent. Because of uncertainty in the market, the company’s financial analyst predicts that the likelihood that the worst-case scenario happening is 20%; and the likelihood of the best-case scenario occurring is 30%. Based upon the net present value method of capital budgeting should management undertake this project?

Answer 1

NPV = Present value of future inflows - initial outflow

Calculation of future inflows:-

Expected increase in EBDT :-

		Year 1		Year 2		Year 3		Year 4		Year 5
Scenerios	Probabiltiy	EBDT	P * EBDT	EBDT	P * EBDT	EBDT	P * EBDT	EBDT	P * EBDT	EBDT	P * EBDT
Expected	50%	75000	37500	75000	37500	90000	45000	90000	45000	60000	30000
Worst	20%	50000	10000	60000	12000	75000	15000	75000	15000	45000	9000
Best	30%	100000	30000	100000	30000	120000	36000	120000	36000	75000	22500
Expected EBDT			77500		79500		96000		96000		61500

Depreciation at straight line basis = (200000+20000)/5 = $44000 each year

Calculation of PV Net cash inflows after tax

	Year 1	Year 2	Year 3	Year 4	Year 5
EBDT	77500	79500	96000	96000	61500
Less- Dep	44000	44000	44000	44000	44000
	33500	35500	52000	52000	17500
Less- Tax @ 30%	10050	10650	15600	15600	5250
Earnings after tax	23450	24850	36400	36400	12250
Add- Dep	44000	44000	44000	44000	44000
Net operating cash inflows	67450	68850	80400	80400	56250
Less - Removal charges	0	0	0	0	5000
Net cash inflow	67450	68850	80400	80400	51250
PV factor	0.909091	0.826446	0.751315	0.683013	0.620921
PV of cash flow	61318.18	56900.83	60405.71	54914.28	31822.22

PV of Total cash inflows in 5 years = $265,361.22

Less- Initial cash outflow    = $ 220,000.00

NPV = $ 45,361.22

Management should undertake this project considering positive NPV