3. Analysis of an expansion project Companies invest in expansion projects with
ID: 2652008 • Letter: 3
Question
3. Analysis of an expansion project Companies invest in expansion projects with the expectation of increasing the earnings of its business. Consider the case of Garida Co.: Garida Co. is considering an investment that will have the following sales, variable costs, and fixed operating costs: This project will require an investment of $25,000 in new 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 (NPV) would be when using accelerated depredation. Determine what the project's net present value (NPV) would be when using accelerated depreciation. $72,532 $58,026 $87,038 $83,412 Now determine what the project?s NPV would be when using straight-line depreciation, r I Using the depredation method will result in the highest NPV for the project. No other firm would take on this project if Garida tums 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 $600 for each year of the four-year project?Explanation / Answer
Gracia Company
(‘a) Calculation of NPV when accelerated depreciation is used
Particulars
Year 1
Year 2
Year 3
Year 4
Total
Unit Sales
5500
5200
5700
5820
Selling Price Per unit (a)
42.57
43.55
44.76
46.79
Variable Cost per unit (b)
22.83
22.97
23.45
23.87
Contribution per unit (a-b)
19.74
20.58
21.31
22.92
Total Contribution ( Contribution per unit x units)
108,570
107,016
121,467
133,394
Less :Fixed Cost
66750
68950
69690
68900
EBDT
41820
38066
51777
64494
Depreciation ( $ 25000 x rate)
8250
11250
3750
1750
25000
EBT
33570
26816
48027
62744
EAT ( EBT x 0.60)
20142
16089.60
28816.20
37646.64
Cash Flow ( EAT + Depreciation)
28392
27339.60
32566.20
39396.64
PVIF @ 11 %
0.90
0.81
0.73
0.66
Present Value of Cash Flow
25578.38
22189.43
23812.12
25951.79
97532
We know that NPV= Present value of cash inflow- Initial Investment
NPV= 97532-25000
NPV= $72,532
(‘b) Calculation of NPV when Straight Line depreciation is used
Particulars
Year 1
Year 2
Year 3
Year 4
TOTAL
EBDT
41820
38066
51777
64494.40
Depreciation ( 25000/4)
6250
6250
6250
6250
25000
EBT
35570
31816
45527
58244
EAT
21342
19089.60
27316.20
34946.64
Cash Flow
27592
25339.60
33566.20
41196.64
PVIF
0.90
0.81
0.73
0.66
Present Value of Cash Inflow
24857.66
20566.19
24543.32
27137.50
97105.00
Hence NPV= 97105-25000
NPV= $72105
(‘c) Using Accelerated method of depreciation will result highest NPV of $ 72532.
(‘d) Revised NPV
We know that PVAF for 4 year @ 11 % is 3.102
If Reduction in Cash Flow is $ 600 in each year of project
Then reduction in NPV= 600 x 3.102
Reduction in NPV= $ 1861.20
Hence revised NPV= $ 72532- $ 1861
Revised NPV= $ 70671
Particulars
Year 1
Year 2
Year 3
Year 4
Total
Unit Sales
5500
5200
5700
5820
Selling Price Per unit (a)
42.57
43.55
44.76
46.79
Variable Cost per unit (b)
22.83
22.97
23.45
23.87
Contribution per unit (a-b)
19.74
20.58
21.31
22.92
Total Contribution ( Contribution per unit x units)
108,570
107,016
121,467
133,394
Less :Fixed Cost
66750
68950
69690
68900
EBDT
41820
38066
51777
64494
Depreciation ( $ 25000 x rate)
8250
11250
3750
1750
25000
EBT
33570
26816
48027
62744
EAT ( EBT x 0.60)
20142
16089.60
28816.20
37646.64
Cash Flow ( EAT + Depreciation)
28392
27339.60
32566.20
39396.64
PVIF @ 11 %
0.90
0.81
0.73
0.66
Present Value of Cash Flow
25578.38
22189.43
23812.12
25951.79
97532
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