Question

3. Analysis of an expansion project

Companies invest in expansion projects with the expectation of increasing the earnings of its business.

Consider the case of Garida Co.:

Garida Co. 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	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	$41,000	$41,670	$41,890	$40,100

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. Garida 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.

$72,774

$75,938

$50,626

$63,282

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.

No other firm would take on this project if Garida turns it down. How much should Garida 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 $400 for each year of the four-year project?

$1,055

$1,365

$745

$1,241

Garida spent $1,500 on a marketing study to estimate the number of units that it can sell each year. What should Garida do to take this information into account?

Increase the NPV of the project $1,500.

Increase the amount of the initial investment by $1,500.

The company does not need to do anything with the cost of the marketing study because the marketing study is a sunk cost.

Answer 1

K2 : X V fx --15000*(1-25%) A B C D E F Sale Contributio Fixed 1 Year units In per unit costs Depreciation PBT 20 1 4,200 $ 17.67 $ 41,000 $ $ 33,214 4 2 4,100 $ 16.55 $ 41,670 $ $ 26,185 3 4,300 $ 16.29 $ 41,890 $ $ 28,157 4 4,400 $ 18.64 $ 40,100 $ $ 41,916 G H I J K L M N Depreci Operating Total cash Present Tax@25% PAT ation cash flows Investment flows PVIF@11% value (11,250)| (11,250) 1.000 $ -11,250 $ 8,304 $ 24,911 $ - $ 24,911 24,911 0.901 $ 22,442 $ 6,546 $ 19,639 $ - $ 19,639 19,639 0.812 $ 15,939 $ 7,039 $ 21,118 $ - $ 21,118 21,118 0.731 $ 15,441 $ 10,479 $ 31,437 $ - $ 31,437 31,437 0.659 $ 20,709 Net present value $ 63,281 Sale Contributio Fixed Depreci Operating Total cash Present 10 Year units in per unit costs Depreciation PBT Tax@25% PAT l ation cash flows Investment flows PVIF@11% value 11 o (15,000) (15,000) 1.000 $ -15,000 12 1 4,200 $ 17.67 $ 41,000 $ 3,750 $ 29,464 $ 7,366 $ 22,098 $ 3,750 $ 25,848 25,848 0.901 $ 23,286 13 2 4,100 $ 16.55 $ 41,670 $ 3,750 $ 22,435 $ 5,609 $ 16,826 $ 3,750 $ 20,576 20,576 0.812 $ 16,700 14 3 4,300 $ 16.29 $ 41,890$ 3,750 $ 24,407 $ 6,102 $ 18,305 $ 3,750 $ 22,055 22,055 0.731 $ 16,127 15 4 4,400 $ 18.64 $ 40,100 $ 3,750 $ 38,166 $ 9,542 $ 28,625 $ 3,750 $ 32,375 32,375 0.659 $ 21,326 16 17 Net present value $ 62,439 18 19 NPV under 100% bonus $ 63,282 20 NPV under SLM $ 62,439 21 Using the 100% bonus depreciation will result in the highest NPV for the project. 22 Reduction in cash flows $ 1,241 =PV(11%,4,-400) 23 Correct option is "The company does not need to do anything with the cost of the marketing study 24 because the marketing study is a sunk cost"

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