Deer Valley Lodge, a ski area near Salt Lake City, has plans to eventually add f

Question

Deer Valley Lodge, a ski area near Salt Lake City, has plans to eventually add five new chairlifts. Suppose that one of the lifts costs $2.2 million, and preparing the slope and installing the lift costs another $1.48 million. The lift will allow 300 additional skiers on the slopes, but there are only 40 days a year when the lodge needs the extra capacity. (Assume that Deer Valley will sell all 300 lift tickets on those 40 days). Running the new lift will cost $500 a day for the entire 200 days the lodge is open. Assume that lift tickets at Deer Valley cost $65 a day and added cash expenses for each skier-day are $9. The new lift has an economic life of 20 yrs. 1. Assume that the before tax required rate of return for Deer Valley is 14%. Compute the before tax NPV of the new lift and advise the managers of Deer Valley about whether adding the lift will be a profitable investment. 2. Assume that the after tax required rate of return for Deer Valley is 8%, the income tax rate is 40%, and the MACRS recovery period is 10 years. Compute the after tax NPV of the new lift and advise the managers of Deer Valley about whether adding the lift will be a profitable investment. 3. What subjective factors would affect the investment decisions?

Explanation / Answer

1. Investment = $2,000,000 + $1,300,000 = $3,300,000 Annual cash inflow = 300 skiers x 40 days x $55/skier-day = $660,000 Annual cash outflow = (200 days x $500/day) = $100,000 PV of cash flows @ 14% = ($660,000 - $100,000) x 6.6231 = $3,708,953 NPV = $3,708,953 - $3,300,000 = $408,953 The new lift will create value of $408,953, so it is a profitable investment. 2. After-tax cash flows = $560,000 x .6 = $336,000 PV of after-tax cash flows @ 8% = $336,000 x 9.8181 = $3,298,897 PV of tax savings = $3,300,000 x .4 x .7059 (from Exhibit 11-7) = $936,540 NPV after-tax = $3,298,897 + $936,540 - $3,300,000 = $935,438 The investment in the lift is more profitable on an after-tax basis than on a pretax basis. 3. Subjective factors that might affect this decision include: (please reword) ? Profits on sales of food, rental of equipment, and other items purchased by the additional skiers. ? More satisfied customers because of less crowding on the days that the additional lift does not result in additional skiers being attracted to Deer Valley. ? Additional skiers may not be as many as estimated if the weather is poor.

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