Question

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Companies invest in expansion projects with the expectation of increasing the eamings of its business. Consider the case of Garida Co.: Garida Co. is considering an investment that will have the following sales, ariable costs, and fixed operating costs: Year 1 Year 2 Year 3 Year 4 3,500,000 ,200 ,250 $38.50 $39.88 $40.15 $41.55 $22.34$22.85 $23.67 $23.87 Fixed operating costs except depreciation $37,000 $37,500 $38,120 $39,560 7% Unit sales Sales price Variable cost per unit Accelerated depreciation rate 45% 33% 15% This project will require an investment of $15,000 inne equipment. The equipment will have no salvage value at the end of the project's four-year life. Garida 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 (NP) would be when using accelerated depreciation. Determine what the project's net present value (NPV) would be when using accelerated depreciation. O $38,789 O $34,479 O $43,099 O $51,719 Now determine what the project's NPV would be when using straight-line depreciation. Using the depreciation methad 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 $500 for each year of the four-year project? $1,706 $1,551 O $931 O $1,318

Answer 1

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Ans a		Computation of NPV using Acceperated depreciation method
				Year -0	Year -1	Year -2	Year -3	Year -4
		initial investment		-15000
	i	unit sales			3,500	4,000	4,200	4,250
	ii	Sales price			38.50	39.88	40.15	41.55
	iii	variable cost			22.34	22.85	23.67	23.87
	iv=ii-iii	Contribution per unit			16.16	17.03	16.48	17.68
	v=i*iv	Total contribution			56,560	68,120	69,216	75,140
	vi	Fixed cost			37,000	37,500	38,120	39,560
	vii	Depreciation rate			33%	45%	15%	7%
	viii	Depreciation amount			4,950	6,750	2,250	1,050
	ix=v-vi-viii	Profit before tax			14,610	23,870	28,846	34,530
	x=ix*40%	Tax @ 40%			5,844	9,548	11,538	13,812
	xi=ix-x	Profit after tax			8,766	14,322	17,308	20,718
	xii=xi+viii	Operating cash flow			13,716	21,072	19,558	21,768
	xiii=xii+viii	Total cash flow		-15000	13,716	21,072	19,558	21,768
	xiv	PVIF @ 11%		1.0000	0.9009	0.8116	0.7312	0.6587
	xv=xiii*xiv	present value		-15000	12,357	17,103	14,300	14,339	43,099
		Therefore NPV =	43099
Ans b	Computation of NPV using stratight line depreciation
				Year -0	Year -1	Year -2	Year -3	Year -4
		initial investment		-15000
		Total contribution		-	56,560	68,120	69,216	75,140
		Fixed cost			37,000	37,500	38,120	39,560
		Depreciation amount			3,750	3,750	3,750	3,750
		Profit before tax			15,810	26,870	27,346	31,830
		Tax @ 40%			6,324	10,748	10,938	12,732
		Profit after tax			9,486	16,122	16,408	19,098
		Operating cash flow			13,236	19,872	20,158	22,848
		Total cash flow		(15,000)	13,236	19,872	20,158	22,848
		PVIF @ 11%		1.0000	0.9009	0.8116	0.7312	0.6587
		present value		(15,000)	11,924	16,129	14,739	15,051	42,843
Ans c		using Accelerated depreciation method will result in the hiehgest NPV for the project
Ans d				Year -1	Year -2	Year -3	Year -4
	i	reduction in after tax cash flow		500	500	500	500
	ii	PVIF @ 11%		0.9009	0.8116	0.7312	0.6587
	iii=i*ii	present value		450	406	366	329	1,551
		Correct answer =	1,551
Ans e		Correct answer is option : Increase the amount of the initial investment by $9000