Question

Companies invest in expansion projects with the expectation of increasing the earnings of its business. Consider the case of McFann Co.: McFann Co. is considering an investment that will have the following sales, variable costs, and fixed operating costs: Unit sales Sales price Variable cost per unit Fixed operating costs Year 1 3,500 $38.50 $22.34 $37,000 Year 2 4,000 $39.88 $22.85 $37,500 Year 3 4,200 $40.15 $23.67 $38,120 Year 4 4,250 $41.55 $23.87 $39,560 This project will require an investment of $15,000 in new equipment. Under the new tax law, the equipment is eligible for 100% bonus deprecation at t = 0, so it will be fully depreciated at the time of purchase. The equipment will have no salvage value at the end of the project's four-year life. McFann pays a constant tax rate of 25%, and it has a weighted average cost of capital (WACC) of 11%. Determine what the project's net present value (NPV) would be under the new tax law. Determine what the project's net present value (NPV) would be under the new tax law. $66,283 $49,712 $55,236 $63,521 Now determine what the project's NPV would be when using straight-line depreciation. Using the depreciation method will result in the highest NPV for the project.

Answer 1

Formula 1 0 15000 3500 38.5 22.34 134750 78190 4200 40.15 23.67 168630 99414 38120 4000 39.88 22.85 159520 91400 37500 0 30620 7655 22965 4250 41.55 23.87 176587.5 101447.5 39560 u*vc 37000 Year (n) Initial investment (11) Unit sales (u) Price per unit (p) Variable cost per unit (vc) Total Sales (5) Total variable cost (VC) Fixed operating cost (FC) Depreciation (D) EBIT Tax @ 25% Net income (NI) Add: Depreciation (D) Operating Cash Flow (OCF) Free cash Flow (FCF) Discount factor @ 11% PV of FCF NPV 19560 100% bonus depreciation S-VC-FC-D EBIT*25% EBIT-Tax 31096 35580 8895 4890 14670 23322 26685 15000 -15000 -3750 -11250 15000 3750 - 11250 1.0000 -11250 55236 22965 NI+D OCF-11 1/(1+11%)^n FCF*Discount factor Sum of all PVs 14670 14670 0.9009 13216 22965 0.8116 186391 23322 23322 0.7312 17053 26685 26685 0.6587| 17578

1). NPV under the new tax law is 55,236.

Formula 1 1 2 3 4 15000 u*p utvc ve Year (n) Initial investment (11) Unit sales (u) Price per unit (p) Variable cost per unit (vc) Total Sales (5) Total variable cost (VC) Fixed operating cost (FC) Depreciation (D) EBIT Tax @ 25% Net income (NI) Add: Depreciation (D) Operating Cash Flow (OCF) Free cash Flow (FCF) Discount factor @ 11% PV of FCF NPV 11/4 S-VC-FC-D EBIT*25% EBIT-Tax 0 35001 38.5 22.34 1347501 78190 37000 3750 15810 3952.5 11857.5 3750 15607.5 15607.5 0.9009) 14061 4000 39.88 22.85 1595201 1595201 91400 37500 3750 26870 6717.5 20152.5 3750 23902.5 23902.5 0.8116 19400 4200 40.151 23.67 168630 99414 38120 3750 27346 6836.5 20509.5 3750 24259.5 24259.5 0.7312 17738 4250 41.55 23.87| 176587.5 101447.5 39560 3750 31830 7957.51 23872.5 3750 27622.5 27622.5 0.6587 18196 o ol 0 NI+D OCF-11 1/(1+11%)^n FCF*Discount factor Sum of all PVS 0 - 15000 1.0000 - 15000 54395

2). NPV, using straight line depreciation over 4 years, is 54,395.

3). Using 100% bonus depreciation method results in highest NPV for the project.

4). NPV should be reduced by the present value of the after-tax net cash flow reduction which is 400*(1-(1+11%)^-4)/11% = 1,241

5). The current after-tax market value of the truck is an opportunity cost as the company loses out on $12,000 which it would have, otherwise earned, if it had sold the truck instead of using it. So, the initial investment amount needs to be increased by $12,000.