Garida Co. is considering an investment that will have the following sales, vari
ID: 2657772 • Letter: G
Question
Garida 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 4,400 $29.82 $30.00 $30.31 $33.19 $12.15$13.45 $14.02 14.55 Fixed operating costs except depreciation $41,000 $41,670 $41,890$40,100 701 4,100 4,300 Unit sales Sales price Variable cost per unit 4,200 Accelerated depreciation rate 3390 4590 15% 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. 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 depreciation Determine what the project's net present value (NPV) would be when using accelerated depreciation O $49,534 O $59,441 O $56,964 O $39,627 Now determine what the project's NPV would be when using straight-line depreciation Using the depreciation method will result in the highest NPV for the projectExplanation / Answer
Since NPV for the project depends on the initial investment as well as the annual cashflows generated by it, the same has been tabulated and calculated in the below tables.
Answer 1. In case of accelerated depreciation, the project's NPV may be calculated as below:
Accelerated Depreciation
Year 1
Year 2
Year 3
Year 4
Data Provided
Initial investment
Cost of Equipment (zero salvage value) (A)
$15,000
Annual revenues and costs
Unit Sales (B)
4,200
4,100
4,300
4,400
Sales Price (C)
$29.82
$30.00
$30.31
$33.19
Sales revenues (D = B*C)
$125,244
$123,000
$130,333
$146,036
Variable Cost per unit (E)
$12.15
$13.45
$14.02
$14.55
Variable expenses (F = B*E)
$51,030
$55,145
$60,286
$64,020
Fixed out-of-pocket operating costs (G)
$41,000
$41,670
$41,890
$40,100
Depreciation rate (H)
33%
45%
15%
7%
Depreciation expense (I = A*H)
$4,950
$6,750
$2,250
$1,050
Company’s discount rate (WACC)
11%
Calculated Values
Profit before tax (J = D – F – G – I)
$28,264
$19,435
$25,907
$40,866
Tax payable (@40% tax rate) (K = 40% * J)
$11,306
$7,774
$10,363
$16,346
Annual cashflow (CF = D – F – G – K)
$21,908.4
$18,411.0
$17,794.2
$25,569.6
Discount Factor Calculation
1/(1+11%)
1/(1+11%)^2
1/(1+11%)^3
1/(1+11%)^4
Discount Factor Values (DF)
0.90
0.81
0.73
0.66
Present Value of Cashflows (CF*DF)
$19,737.30
$14,942.78
$13,010.97
$16,843.49
Total Present Value of Cashflows (PV = Sum of all 4 years)
$64,534.53
Net Present Value (NPV = PV – A)
$49,534.53
Thus the NPV for the project in case of accelerated depreciation is $49,534.
Answer 2. In case of straight-line depreciation, the project's NPV may be calculated as below:
Straight Line Depreciation
Year 1
Year 2
Year 3
Year 4
Data Provided
Initial investment
Cost of Equipment (zero salvage value) (A)
$15,000
Annual revenues and costs
Unit Sales (B)
4,200
4,100
4,300
4,400
Sales Price (C)
$29.82
$30.00
$30.31
$33.19
Sales revenues (D = B*C)
$125,244
$123,000
$130,333
$146,036
Variable Cost per unit (E)
$12.15
$13.45
$14.02
$14.55
Variable expenses (F = B*E)
$51,030
$55,145
$60,286
$64,020
Fixed out-of-pocket operating costs (G)
$41,000
$41,670
$41,890
$40,100
Depreciation rate (H)
25%
25%
25%
25%
Depreciation expense (I = A*H)
$3,750
$3,750
$3,750
$3,750
Company’s discount rate (WACC)
11%
Calculated Values
Profit before tax (J = D – F – G – I)
$29,464
$22,435
$24,407
$38,166
Tax payable (@40% tax rate) (K = 40% * J)
$11,786
$8,974
$9,763
$15,266
Annual cashflow (CF = D – F – G – K)
$21,428.4
$17,211.0
$18,394.2
$26,649.6
Discount Factor Calculation
1/(1+11%)
1/(1+11%)^2
1/(1+11%)^3
1/(1+11%)^4
Discount Factor Values (DF)
0.90
0.81
0.73
0.66
Present Value of Cashflows (CF*DF)
$19,304.86
$13,968.83
$13,449.68
$17,554.92
Total Present Value of Cashflows (PV = Sum of all 4 years)
$64,278.30
Net Present Value (NPV = PV – A)
$49,278.30
Thus the NPV for the project in case of straight-line depreciation is $49,278.
Answer 3. Thus, using the Accelerated Depriciation method will result in the highest NPV for the project. This is because accelerated depreciation results in lower Profit Before Tax in the initial two years which lowers the tax outflow and hence increases the cash inflow in these years. Since the discount factor in the initial two years is higher compared to the latter two, this results in marginally higher NPV for this method.
Answer 4. Since the project will result in a reduction of net after-tax cashflows of one of Garida's divisions by $700 in each of the four years of the project. The corresponding reduction in NPV required in order to factor in the above mentioned cashflow reduction may be calculated as given below:
Discounted Values (Product Cashflow*Discount Factor)
Annual reduction in after-tax cashflows
Discount Factor Calculation
Discount Factor
Project
Year 1 cashflow
$700
1/(1+11%)
0.90
$630.63
Year 2 cashflow
$700
1/(1+11%)^2
0.81
$568.14
Year 3 cashflow
$700
1/(1+11%)^3
0.73
$511.83
Year 4 cashflow
$700
1/(1+11%)^4
0.66
$461.11
NPV (Sum of discounted values of each year)
$2,171.71
Thus, Garida should reduce the NPV of this project by $2,172 in order to account for the annual $700 reduction in net after-tax cashflows in one of it's other divisions.
Answer 5. Since Garida spent $1,750 on a marketing study to estimate the number of units that it can sell each year, this should be treated as a sunk cost and cannot be allocated towards the NPV of the project. Thus, the company does not need to do anything with this cost with respect to the project NPV.
Accelerated Depreciation
Year 1
Year 2
Year 3
Year 4
Data Provided
Initial investment
Cost of Equipment (zero salvage value) (A)
$15,000
Annual revenues and costs
Unit Sales (B)
4,200
4,100
4,300
4,400
Sales Price (C)
$29.82
$30.00
$30.31
$33.19
Sales revenues (D = B*C)
$125,244
$123,000
$130,333
$146,036
Variable Cost per unit (E)
$12.15
$13.45
$14.02
$14.55
Variable expenses (F = B*E)
$51,030
$55,145
$60,286
$64,020
Fixed out-of-pocket operating costs (G)
$41,000
$41,670
$41,890
$40,100
Depreciation rate (H)
33%
45%
15%
7%
Depreciation expense (I = A*H)
$4,950
$6,750
$2,250
$1,050
Company’s discount rate (WACC)
11%
Calculated Values
Profit before tax (J = D – F – G – I)
$28,264
$19,435
$25,907
$40,866
Tax payable (@40% tax rate) (K = 40% * J)
$11,306
$7,774
$10,363
$16,346
Annual cashflow (CF = D – F – G – K)
$21,908.4
$18,411.0
$17,794.2
$25,569.6
Discount Factor Calculation
1/(1+11%)
1/(1+11%)^2
1/(1+11%)^3
1/(1+11%)^4
Discount Factor Values (DF)
0.90
0.81
0.73
0.66
Present Value of Cashflows (CF*DF)
$19,737.30
$14,942.78
$13,010.97
$16,843.49
Total Present Value of Cashflows (PV = Sum of all 4 years)
$64,534.53
Net Present Value (NPV = PV – A)
$49,534.53
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