Question

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

Consider the case of Yeatman Co.:

Yeatman 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	3,000	3,250	3,300	3,400
Sales price	$17.25	$17.33	$17.45	$18.24
Variable cost per unit	$8.88	$8.92	$9.03	$9.06
Fixed operating costs	$12,500	$13,000	$13,220	$13,250

This project will require an investment of $10,000 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. Yeatman 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.

$31,930

$30,599

$26,608

$23,947

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 Yeatman turns it down. How much should Yeatman 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 $500 for each year of the four-year project?

$1,163

$1,551

$1,318

$1,706

Yeatman spent $2,250 on a marketing study to estimate the number of units that it can sell each year. What should Yeatman 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.

Increase the NPV of the project $2,250.

Increase the amount of the initial investment by $2,250.

Answer 1

solution: 8.42 1.Calculation of NPV (Bonus Depreciation at t=0) sale price per unit Less : variable cost per unit Contribution margin per unit x unit sales Total contribution Les : fixed cost Less : depreciation** EBT tax at 25% EAT Add : depreciation OCF Inital cost total cash flow discount factor at 11% PV NPV (sum of PV) 17.25 17.33 17.45 18.24 -8.88 -8.92 -9.03 -9.06 8.37 8.41 9.18 3000.00 3250.00 3300.00 3400.00 25110.00 27332.50 27786.00 31212.00 -12500.00 -13000.00 -13220.00 -13250.00 -10000.00 0.00 0.00 0.00 0.00 -10000.00 12610.00 14332.500 14566.00 17962.00 2500.00l-3152.50 -3583.13 -3641.50 4490.50 -7500.00 9457.50 10749.38 10924.50 13471.50 10000.00 0.00 0.00 0.00 0.00 2500.00 9457.50 10749.38 10924.50 13471.50 -10000.00 -7500.00 9457.50 10749.38 10924.50 13471.50 1.00000 0.90090 0.81162 0.73119 0.65873 -7500.00 8520.27 8724.43 7987.90 8874.09 26,607


2.Calculation of NPV (using SLM method) sale price per unit Less : variable cost per unit Contribution margin per unit x unit sales Total contribution Les : fixed cost Less : depreciation (10000/4) EBT tax at 40% EAT Add : depreciation OCE Inital cost total cash flow discount factor at 11% 0 1 4 17.25 17.33 17.45 18.24 -8.88 -8.92 -9.03 -9.06 8.37 8.41 8.42 9.18 3000.00 3250.00 3300.00 3400.00 | 25110.00 27332.50 27786.00] 31212.00 | -12500.00 -13000.00 -13220.00 -13 250.00 -2500.00 -2500.00 -2500.00 -2500.00 10110.00 11832.50 12066.00 15462.00 -4044.00 -4733.00 -4826.40 -6184.80 6066.00 7099.50 7239.60 9277.20 2500.00 2500.00 2500.00 8566.00 9599.50 9739.60| 11777.20 -10000.00 -10000.00 8566.00 9599.500 9739.60 11777.20 1.00000 0.90090 0.81162 0.73119 0.65873 -10000.00 7717.12 7791.17 7121.51 7758.01 20,388 PV NPV (sum of PV) 3. Using the Bonus depreciation method will result in the highest NPV for the project. 4) reduction in net after-tax cash flows X PVIFA (11%,4)** reduction in NPV required 500 3.10245 1551 5. The company does not need to do anything with the cost of the marketing study because the marketing study is a sunk cost. **factor working : PVIFA(R%,n) PVIFA(11%,4) (1-(1+r)^-n)/ (1-(1.11^-4))/0.11 3.10245