Question

3. The New Orleans Mosquito Control Corporation (NOMCC) has hired you as a consultant to evaluate the NPV of their proposed frog ranch. NOMCC plans to breed long-tongue frogs and sell them as ecologically desirable mosquito-control mechanisms in the hopes of eliminating the West Nile Virus. They anticipate that the business will continue in perpetuity. Following negligible start-up costs, NOMCC will incur the following nominal cash flows at the end of the year. Revenues Labor costs Other costs $150,000 75,000 20,000 The company will lease machinery from a firm for $10,000 per year. (The lease payment starts at the end of year 1.) The payments of the lease are fixed in nominal terms. Sales will increase at 5 percent per year in real terms. Labor costs will increase at 3 percent per year in real terms. Other costs will increase at 1 percent per year in real terms. The rate bf inflation is expected to be 1.5 percent next year. The real cost of capital for revenues and costs is 10 percent. The lease payments are risk-free: therefore, they must be discounted at the risk-free rate. The real risk-free rate is 2 percent. There are no taxes. All cash flows occur at year-end. What is the NPV of NOMCC's proposed frog ranch today?

4) Franco’s athletic club is planning an expansion. The owner is either going to build a completely new building or just add on to the existing facility. A new building will cost $10 million, but it is expected to increase revenues by $2 million (before taxes) per year for ten years. An add-on to the current facility will only cost $500,000, but projections are that it will lead to an increase in revenues of only $150,000 (before taxes) per year for ten years. The capital outlay for either choice will be depreciated on a straight-line basis over the ten-year life of the project. Cash flows from depreciation tax savings should be considered to have the same risk as other cash flows. Franco’s Athletic Club has a marginal tax rate of 21% and a cost of capital of 10%. Find the IRR of each project, the incremental IRR, and determine which type of an expansion to recommend to the owner.

Answer 1

For New Building:

We can construct below Income statement:

	Year	0	1	2	3	4	5	6	7	8	9	10
New Building	Revenue	0	2000	2000	2000	2000	2000	2000	2000	2000	2000	2000
	(Depreciation)		1000	1000	1000	1000	1000	1000	1000	1000	1000	1000
	Profit before Tax		1000	1000	1000	1000	1000	1000	1000	1000	1000	1000
	Tax(@ 21%)		210	210	210	210	210	210	210	210	210	210
	Net Income		790	790	790	790	790	790	790	790	790	790

All Calculations are in '000s

Here Depreciation is calculated by considering Salvage value as 0

i.e. Depreciation = (Original Cost - Salvage)/(Years over which investment to depreciated)

therefore, Depreciation = 10 Mn/10 = 1 Mn

Cashflow Statement:

Year	0	1	2	3	4	5	6	7	8	9	10
Income		790	790	790	790	790	790	790	790	790	790
Depreciation		1000	1000	1000	1000	1000	1000	1000	1000	1000	1000
Cashflows	-10000	1790	1790	1790	1790	1790	1790	1790	1790	1790	1790

From the Cash flows, we can find the IRR using standard standard IRR formula in excel or using financial calculator.

Which gives us value of 12%

Therefore IRR for new facility is 12%

Similarly we can do for

Add on Current Facility

Income Statement:

add-on to the current facility	Revenue	0	150	150	150	150	150	150	150	150	150	150
	Depreciation		50	50	50	50	50	50	50	50	50	50
	Profit before Tax		100	100	100	100	100	100	100	100	100	100
	Tax(@21%)		21	21	21	21	21	21	21	21	21	21
	Income		79	79	79	79	79	79	79	79	79	79

Cashflow Statement

Year	0	1	2	3	4	5	6	7	8	9	10
Income		79	79	79	79	79	79	79	79	79	79
Depreciation		50	50	50	50	50	50	50	50	50	50
Cashflows	-500	129	129	129	129	129	129	129	129	129	129

Again using excel IRR formula or financial calculator,

IRR for Add on current facility is 22%

Incremental IRR can be calculated by finding the difference between the cashflows of both project.

Year	0	1	2	3	4	5	6	7	8	9	10
New Building	-10000	1790	1790	1790	1790	1790	1790	1790	1790	1790	1790
Add-on to the current facility	-500	129	129	129	129	129	129	129	129	129	129
Cashflows	-9500	1661	1661	1661	1661	1661	1661	1661	1661	1661	1661

Again using IRR formula from excel or financial calculator,

We can Find Incremental IRR = 12%

Now,

Increment IRR > Cost of Capital

i.e. 12% > 10%

hence, we can say that constructing new building will be more profitable as compared to add on to existing facility.