Question

Better Mousetraps has developed a new trap. It can go into production for an initial investment in equipment of $25.2 million. The equipment will be depreciated straight line over 6 years, but, in fact, it can be sold after 6 years for $671,000. The firm believes that working capital at each date must be maintained at a level of 20% of next year’s forecast sales. The firm estimates production costs equal to $9.50 per trap and believes that the traps can be sold for $20 each. Sales forecasts are given in the following table. The project will come to an end in 6 years, when the trap becomes technologically obsolete. The firm’s tax bracket is 40%, and the required rate of return on the project is 12%.

Year:	0	1	2	3	4	5	6	Thereafter
Sales (In Millions)	0.00	0.66	0.75	1.00	1.00	0.44	0.20	0

a. What is project NPV? (Negative amount should be indicated by a minus sign. Do not round intermediate calculations. Enter your answer in millions rounded to 3 decimal places.)

b. By how much would NPV increase if the firm uses double-declining balance depreciation with a later switch to straight-line when remaining project life is only two years? (Do not round intermediate calculations. Enter your answer in millions rounded to 3 decimal places.)

Answer 1

Part A: Project NPV is $12.161 mn as per the following calculations:

Method 1: Straight line depreciation
Year (all figures in $mn)	0	1	2	3	4	5	6
Initial outlay	-25.200
Salvage value							0.671
Revenue		13.200	15.000	20.000	20.000	8.800	4.000
Cost of good sold		-6.270	-7.125	-9.500	-9.500	-4.180	-1.900
Depreciation tax shield		1.635	1.635	1.635	1.635	1.635	1.635
Free cash flow	-25.200	8.565	9.510	12.135	12.135	6.255	4.406
PV of free cashflow		7.648	7.582	8.638	7.712	3.549	2.232
NPV	12.161

Part B: Project NPV increases by $0.683 mn when we use a double depreciating method followed by straight-line depreciation method, below calculations describe this:

Method 2: Double declining method, followed by straight line
Year (all figures in $mn)	0	1	2	3	4	5	6
Initial outlay	-25.200
Salvage value							0.671
Revenue		13.200	15.000	20.000	20.000	8.800	4.000
Cost of good sold		-6.270	-7.125	-9.500	-9.500	-4.180	-1.900
Depreciation		8.400	5.600	3.733	2.489	2.153	2.153
Depreciation tax shield		3.360	2.240	1.493	0.996	0.861	0.861
Free cash flow	-25.200	10.290	10.115	11.993	11.496	5.481	3.632
PV of free cashflow		9.188	8.064	8.537	7.306	3.110	1.840
NPV	12.844
NPV increase	0.683