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Analysis of an expansion project Companies invest in expansion projects with the expectation of increasing the...

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 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 except depreciation $12,500 $13,000 $13,220 $13,250
Accelerated depreciation rate 33% 45% 15% 7%

This project will require an investment of $15,000 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.

Determine what the project’s net present value (NPV) would be when using accelerated depreciation.

$17,195

$19,774

$15,476

$13,756

Now determine what the project’s NPV would be when using straight-line depreciation. A) $18480 B)$21,174 C)$16938 D)$16092  

Using the _________ (Accelerated, Straightline) 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 $500 for each year of the four-year project?

$931

$1,551

$1,163

$1,318

Fox spent $2,750 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 NPV of the project $2,750.

Increase the amount of the initial investment by $2,750.

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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Answer #1

Answer 1:

Correct answer is:

$17,195

Explanation:

Workings:

As such option A is correct and other options B, C and D are incorrect.

Answer 2:

Correct answer is:

C)$16938

Explanation:

Workings:

Closest option is Option C.

As such option C is correct and other options A, B and D are incorrect.

Answer 3:

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

Answer 4:

Correct answer is:

$1,551

Explanation:

Reduction in annual cash flow = $500

Reduction in NPV = 500 * PV factor of $1 annuity for 4 years at 11% discount

= 500 * (1 - 1/ (1+11%) 4 ) / 11%

= $1,551

As such option B is correct and other options A, C and D are incorrect.

Answer 5:

Correct answer is:

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

Explanation:

Cost of marketing study is a sunk cost. This amount is already spent irrespective whether Fox Co accepts this project or not and as such this cost is irrelevant.

As such option C is correct and other options A and B are incorrect.

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