Question

2. (Free Cash Flows) Procter&Gamble (P&G) wants to become a zero net emission business in 4 years and considers switching to a new environment friendly production technology. Currently, the expected annual total costs of production of P&G are $10 million with the beta of costs equal to 0.7. The new technology will be gradually implemented in all production lines and would require an annual capital expenditure of $2 million for the first 4 years, which is not depreciated and is written off in the same year as production costs. The expected cost savings compared to existing technology are $200,000 in year 1, $400,000 in year 2, $600,000 in year 3, $800,000 in year 4. Starting from year 5 when the technology is fully implemented, the expected annual cost savings are $1,000,000. The beta of the new technology is 0.6. P&G's marginal tax rate is 25%. In your calculations, suppose that risk free rate is 2% and the market risk premium equals 4%. (a) Compute the NPV of implementing the new technology and make a recommendation to P&G of whether it should implement it or not (Hint: Use Excel) (b) Suppose that P&G negotiated a deal with its suppliers that if it implements a new technology, then P&G gets a trade credit which amounts to 35% of its costs. Re-do the exercise in part (a) under this alternative assumption. (c) Re-do the exercise in parts (a) and (b) under a higher marginal tax rate of 35%. Does higher tax rate make the new green techology more or less appealing?

Answer 1

A. PART

CALCULATION OF REQUIRED RATE OF RETURN.

RF+BETA(RM-RF)

RF = RISK FREE RATE OF RETURN

BETA=ALREADY GIVEN IN QUESTION

RISK PREMIUM=RISK FREE MARKET RATE OF RETURN-RISK FREE RATE OF RETUN.

IN THE GIVEN QUESTION

2%+.6(4%)=4.4%

CALCULATION OF PRESENT VALUE

=1/1.044

UNDER NEW SITUATION

COST OF PROJECT = 2 MILLION = $20,00,000

= $20,00,000/4

= $500000

UNDER EXISTING SITUATION = $10,00,000

SAVINGS IN PRODUCTION COST = $10,00,000 - $500000

= $500000

TAX BENEFIT = $500000*(1-.25)

=$375000

PRESENT VALUE OF CASH INFLOW

SR CASH INFLOW PRESENT VALUE VALUE

1. $200000 + $375000 .9578 $550735

2. $400000 + $375000 .9175 $711063

3. $600000 + $375000 .8788 $856830

4. $800000 + $375000 .8418 $989115

CASH FLOW BEFORE TAX     $3107743

TAX RATE 25% $776936

CASH FLOW AFTER TAX $2330807

NPV=PRESENT VALUE OF CASH INFLOW - PRESENT VALUE OF CASH OUTFLOW

=$2330807 - $2000000

=$330807

IT SHOULD BE IMPLEMENTED BECAUSE NPV IS POSITIVE.

B.PART

IF TRADE CREDIT IS GIVEN

CASH OUTFLOW WOULD BE

VALUE OF ASSETS = $20,00,000

LESS: DISCOUNT@35% = $700000

NET VALUE OF ASSETS =$13,00,000

NET PRESENT VALUE

PRESENT VALUE OF CASH INFLOW = AS CALCULATED ABOVE

NET PRESENT VALUE = PRESENT VALUE OF CASH INFLOW - PRESENT VALUE OF CASH OUTFLOW

= $2330807 - $13,00,000

= $1330807

SINCE NPV IS POSITIVE WE SHOULD ACCEPT THE OPTION.

C.UNDER HIGHER MARGINAL RATE OF TAX

UNDER OPTION 1

PROFIT BEFORE TAX AS CALCULATED ABOVE = $3107743

LESS :- TAX RATE @ 35% = $1087710

PROFIT AFTER TAX = $2020033

NPV = PV OF CASH INFLOW - PV OF CASH OUTFLOW

= $2020033 - $2000000

= $20033

UNDER OPTION 2

PRESENT VALUE OF CASH INFLOW AS CALCULATED ABOVE

CASH INFLOW = $2330807

CASH OUTFLOW AFTER TRADE DISCOUNT AS CALCULATED IN PART B ABOVE

CASH OUTFLOW AS CALCULATED ABOVE = $1300000

NPV = PV OF CASH INFLOW - PV OF CASH OUTFLOW

= $2330807 - $1300000

= $1030807

IN BOTH THE ABOVE SITUATION NPV IS POSITIVE PROJECT CAN BE IMPLEMENTED.