Question

2. Analysis of an expansion project

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

Consider the case of Fox Co.:

Fox 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	5,500	5,200	5,700	5,820
Sales price	$42.57	$43.55	$44.76	$46.79
Variable cost per unit	$22.83	$22.97	$23.45	$23.87
Fixed operating costs except depreciation	$66,750	$68,950	$69,690	$68,900
Accelerated depreciation rate	33%	45%	15%	7%

This project will require an investment of $20,000 in new equipment. The equipment will have no salvage value at the end of the project’s four-year life. Fox pays a constant tax rate of 40%, and it has a weighted average cost of capital (WACC) of 11%. Determine what the project’s net present value (NPV) would be when using accelerated depreciation. (Note: Round your answer to the nearest whole dollar.)

- $60,717

- $87,280

- $68,306

- $75,896

Now determine what the project’s NPV would be when using straight-line depreciation. (Note: Round your answer to the nearest whole dollar.)   

The     depreciation method will result in the highest NPV for the project.

No other firm would take on this project if Fox turns it down. How much should Fox 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? (Note: Round your answer to the nearest whole dollar.)

- $1,241

- $931

- $1,055

- $745

Fox spent $2,500 on a marketing study to estimate the number of units that it can sell each year. What should Fox do to take this information into account?

- Increase the amount of the initial investment by $2,500.

- Increase the NPV of the project $2,500.

-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

FM FN 11m0N FSSPF22888::8888 Year Cost of Equipment Sales (units) Selling Price Variable Cost Contribution Margin per Unit Contribution Margin Depreciation Fixed Costs Net Income Before Taxes Tax @ 40% Add Depreciation Net Cash Flow NPV FOFP FQ FR FS A. NPV - Accelerated Depreciation 0 1 2 3 4 $ (20,000) $ 5,500 $ 5,200 $ 5,700 $ 5,820 43 $ 44$ 45 $ 47 $ (23) $ (23) $ (23) $ (24) $ 20 $ 21 $ 21 | $ 23 $ 108,570 $ 107,016 $ 121,467 $ 133,394 $ (6,600) $ (9.000) $ (3,000) $ (1,400) $ (66,750) $ (68,950) $ (69,690) $ (68,900) $ 35,220 $ 29,066 $ 48,777 $ 63,094 $ (14,088) $ (11,626) $ (19,511) $ (25,238) $ 6,600 $ 9,000 $ 3,000 $ 1,400 $(20,000) $ 27,732 $ 26,440 $ 32,266 $ 39,257 $ 75,895 Option D FU FVFWFX FYFZ B. NPV - Straight Line Depreciation Year 0 1 | 2 | 3 | 4 Cost of Equipment $(20,000) Sales (units) $ 5,500 $ 5,200 $ 5,700 $ 5,820 Selling Price $ 43 $ 44 $ 45 $ 47 Variable Cost $ (23) $ (23) $ (23) $ (24) Contribution Margin per Unit $ 20 $ 21 $ 23 Contribution Margin $ 108,570 $ 107,016 $ 121,467 $ 133,394 Depreciation $ (5,000) $ (5,000) $ (5,000) $ (5,000) Fixed Costs $ (66,750) $ (68,950) $ (69,690) $ (68,900) Net Income Before Taxes $ 36,820 $ 33,066 $ 46,777 $ 59,494 Tax @ 40% $ (14,728) $ (13,226) $ (18,711) $ (23,798) Add Depreciation $ 5,000 $ 5,000 $ 5,000 $ 5,000 Operating Cash Flows $(20,000) $ 27,092 $ 24,840 $ 33,066 $ 40,697 NPV $ 75,553 C. NPV - Reduction in net cash flow Year 0 1 1 2 2 3 4 Cost of Equipment $ (20,000) Sales (units) $ 5,500 $ 5,200 $ 5,700 $ 5,820 Selling Price $ 43 $ 44 $ 45 $ 47 Variable Cost $ (23) $ (23) $ (23) $ (24) Contribution Margin per Unit $ 20 $ 21 $ 21 $ 23 Contribution Margin $ 108,570 $ 107,016 $ 121,467$ 133,394 Depreciation $ (6,600) $ (9,000) $ (3,000 $ (1,400) Fixed Costs $ (66,750) $ (68,950 $ (69690) $ (68,900) $ 35,220 $ 29,066 $ 48,777 $ 63,094 Tax @ 40% $ (14,088) $ (11,626) $ (19,511) $ (25,238) Add Depreciation $ 6,600 $ 9,000 $ 3,000 $ 1,400 Net Cash Flow with reduction $(20,000) $ 27,332 $ 26,040 $ 31,866 $ 38,857 NPV $ 74,654 Option D

FN FO FR FS A. NPV - Accelerated Depreciation -20000 2 Year 3 Cost of Equipment 4 Sales (units) 5 Selling Price 6 Variable Cost 7 Contribution Margin per Unit 8 Contribution Margin 9 Depreciation 10 Fixed Costs 11 Net Income Before Taxes 12 Tax @ 40% 13 Add Depreciation 14 Net Cash Flow 15 NPV 5500 42.57 -22.83 =FP5+FP6 =FP4*FP7 =$FO$3*0.33 -66750 =SUM(FP8:FP10) --FP11*0.4 =-FP9 I=SUM(FP11:FP13) Option D 5200 43.55 -22.97 =FQ5+FQ6 =FQ4*FQ7 =$FO$3*0.45 -68950 =SUM(FQ8:FQ10) --FQ11*0.4 --FQ9 =SUM(FQ11:FQ13) 5700 44.76 -23.45 =FR5+FR6 =FR4*FR7 =$FO$3*0.15 -69690 =SUM(FR8:FR10) --FR11*0.4 --FR9 |=SUM(FR11:FR13) 5820 46.79 -23.87 =FS5+FS6 =FS4*FS7 =$FO$3*0.07 -68900 =SUM(FS8:FS10) --FS11*0.4 --FS9 =SUM(FS11:FS13) =FO3 =NPV(0.11,FP14:FS14)+F014 16 C. NPV - Reduction in net cash flow 14 |-20000 5820 46.79 17 18 Year 19 Cost of Equipment 20 Sales (units) 21 Selling Price 22 Variable Cost 23 Contribution Margin per Unit 24 Contribution Margin 25 Depreciation 26 Fixed Costs 27 Net Income Before Taxes 28 Tax @ 40% 29 Add Depreciation 30 Net Cash Flow with reduction 31 NPV 5500 42.57 -22.83 =FP21+FP22 =FP20*FP23 =$FO$3*0.33 -66750 =SUM(FP24:FP26) --FP27*0.4 --FP25 =SUM(FP27:FP29)-400 5200 43.55 -22.97 =FQ21+FQ22 =FQ20*FQ23 =$FO$3*0.45 |-68950 =SUM(FQ24:FQ26) =-FQ27*0.4 --FQ25 =SUM(FQ27:FQ29)-400 5700 44.76 -23.45 =FR21+FR22 =FR20*FR23 =$FO$3*0.15 -69690 =SUM(FR24:FR26) --FR27*0.4 --FR25 =SUM(FR27:FR29)-400 -23.87 =FS21+FS22 =FS20*FS23 =$FO$3*0.07 -68900 =SUM(FS24:FS26) --FS27*0.4 --FS25 =SUM(FS27:FS29) 400 =F019 =NPV(0.11,FP30:FS30)+FO30

FUFV FW B. NPV - Straight Line Depreciation FX FY FZ o -20000 Year 3 Cost of Equipment 4 Sales (units) 5 Sellina Price 6 Variable Cost 7 Contribution Margin per Unit 8 Contribution Margin 9 Depreciation 10 Fixed Costs 11 Net Income Before Taxes 12 Tax @ 40% 13 Add Depreciation 14 Operating Cash Flows 15 NPV 16 17 18 5500 5200 42.57 43.55 -22.83 -22.97 =FW5+FW6 =FX5+FX6 =FW4*FW7 =FX4*FX7 =$FO$3/4 =FW9 -66750 -68950 =SUM(FW8:FW10) ESUM(FX8:FX10) --FW11*0.4 =-FX11*0.4 --FW9 --FX9 =SUM(FW11:FW13) =SUM(FX11:FX13) 5700 44.76 -23.45 =FY5+FY6 =FY4*FY7 =FX9 -69690 =SUM(FY8:FY10) =-FY11*0.4 --FY9 =SUM(FY11:FY13) 5820 46.79 -23.87 =FZ5+FZ6 =FZ4*FZ7 =FY9 -68900 =SUM(FZ8:FZ10) =-FZ11*0.4 --FZ9 =SUM(FZ11:FZ13) =FV3 =NPV(0.11,FW14:FZ14)+FV14 19

This project will require an investment of $20,000 in new equipment. The equipment will have no salvage value at the end of the project’s four-year life. Fox pays a constant tax rate of 40%, and it has a weighted average cost of capital (WACC) of 11%. Determine what the project’s net present value (NPV) would be when using accelerated depreciation. (Note: Round your answer to the nearest whole dollar.)

$75,896

Now determine what the project’s NPV would be when using straight-line depreciation. (Note: Round your answer to the nearest whole dollar.)

$75553  

The Accelerated Depreciation depreciation method will result in the highest NPV for the project.

No other firm would take on this project if Fox turns it down. How much should Fox 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? (Note: Round your answer to the nearest whole dollar.)

$1,241 (75895-74654)

Fox spent $2,500 on a marketing study to estimate the number of units that it can sell each year. What should Fox do to take this information into account?

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

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