Question

Analysis of an expansion project

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)	4,200	4,100	4,300	4,400
Sales price	$29.82	$30.00	$30.31	$33.19
Variable cost per unit	$12.15	$13.45	$14.02	$14.55
Fixed operating costs except depreciation	$41,000	$41,670	$41,890	$40,100
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.)

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.)

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

No other firm would take on this project if Happy Dog Soap turns it down. How much should Happy Dog Soap 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 $500 for each year of the four-year project?

A) $1,318

B) $1,706

C) $931

D) $1,551

Happy Dog Soap spent $1,750.00 on a marketing study to estimate the number of units that it can sell each year. What should Happy Dog Soap 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 NPV of the project $1,750.00.

C) Increase the amount of the initial investment by $1,750.00.

Answer 1

I have answered all the questions first. Detailed calculations of NPV for both the cases follow after the answers, towards the end.

When using accelerated depreciation, the project’s net present value (NPV) is $ 52,898

When using straight-line depreciation, the project’s NPV is $ 52,727

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

No other firm would take on this project if Happy Dog Soap turns it down. How much should Happy Dog Soap 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 $500 for each year of the four-year project?

Amount to be reduced = PV of annuity of $ 500 over 4 years = A / r x [1 - (1 + r)^-n] = 500 / 11% x [1 - (1 + 11%)^-4] = $ 1,551

Hence, the correct answer is option D) $1,551

Happy Dog Soap spent $1,750.00 on a marketing study to estimate the number of units that it can sell each year. What should Happy Dog Soap do to take this information into account?

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

It's a sunk cost as it's irreversible, incurred, can't be reversed.

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Please see the table below. Please be guided by the second column titled “Linkage” to understand the mathematics. The last row highlighted in yellow is your answer. Figures in parenthesis mean negative values. All financials are in $. Adjacent cells in blue contain the formula in excel I have used to get the final output.

Accelerated Depreciation Case

Straight line depreciation case: