In: Finance
Management of Group R Corporation is considering an expansion in the company’s product line that requires the purchase of an additional $185,000 in equipment with installation cost of $15,000 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: Year 1 $60,000 Year 2 $60,000 Year 3 $75,000 Year 4 $75,000 Year 5 $50,000 Group R Corporation’s income tax rate is 20 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?
Statement showing NPV
Particulras | 0 | 1 | 2 | 3 | 4 | 5 | NPV = Sum of PV |
Purchase cost of equipment | -185000 | ||||||
Instalation cost | -15000 | ||||||
Removal expense | -5000 | ||||||
Increased EBIT | 60000 | 60000 | 75000 | 75000 | 50000 | ||
Depreciation((185000+15000)/5) =200000/5 =40000 pa |
40000 | 40000 | 40000 | 40000 | 40000 | ||
PBT | 20000 | 20000 | 35000 | 35000 | 10000 | ||
Tax rate @ 20% | 4000 | 4000 | 7000 | 7000 | 2000 | ||
PAT | 16000 | 16000 | 28000 | 28000 | 8000 | ||
Add: Depreciation | 40000 | 40000 | 40000 | 40000 | 40000 | ||
Cash flow | 56000 | 56000 | 68000 | 68000 | 48000 | ||
Total cash flow | -205000 | 56000 | 56000 | 68000 | 68000 | 48000 | |
PVIF @ 10% | 1.0000 | 0.9091 | 0.8264 | 0.7513 | 0.6830 | 0.6209 | |
PV (Total cash flow*PVIF) | -205000.00 | 50909.09 | 46280.99 | 51089.41 | 46444.91 | 29804.22 | 19528.63 |
Since NPV is positive management should undertake the project