A firm is considering undertaking a capital investment project. The firm is plan
ID: 2666011 • Letter: A
Question
A firm is considering undertaking a capital investment project. The firm is planning on producing a new line of oversize tennis rackets. The additional equipment needed to produce the new rackets would cost $455,000 initially. This amount will be depreciated straight line to a zero salvage value over a 5 year life. The company has already spent $145,000 on an extensive marketing survey that yielded encouraging results for their project. Also, if the firm decides to make the new rackets they will be unable to sell $165,000 (after tax value) of equipment they had planned on selling. There are no additions to net working capital that result from the project.The project’s marginal revenues and expenses before taxes are given in the following table (the project has a five year life):
(Marginal) Year 1 Year 2 Year 3 Year 4 Year 5
Sales Revenue $440,000 $465,000 $405,000 $325,000 $275,000
Variable Costs 20% of revenue all years----------------------------------
Fixed Costs $60,000 $60,000 $60,000 $60,000 $60,000
Depreciation ? ? ? ? ?
All revenues and expenses are on a cash basis. The firm has a marginal tax rate of 34% and an average tax rate of 25%. The required return on equity is 11.10%, and the firm’s pre-tax cost of debt is 5.00%. The firm employs a 45% debt to capital ratio. The firm considers this project to be about the same level of risk as the typical project for the firm.
Watch your rounding, excessive rounding will result in incorrect answers.
a. What is the project’s NPV? (Show your work by providing a timeline of the initial cost and each year’s Cash Flow from Assets, show the discount rate calculation and also show the NPV equation and the solution.)
Explanation / Answer
1
2
3
4
5
Total
sales
440000
465000
405000
325000
275000
Less:Variable costing
88000
93000
81000
65000
55000
Less:Fixed cost
60000
60000
60000
60000
60000
Interest5%
10237.5
10237.5
10237.5
10237.5
10237.5
Profit before Tax
281762.5
301762.5
253762.5
189762.5
149762.5
Marginal Tax 34%
95799.25
102599.3
86279.25
64519.25
50919.25
Net income
185963.3
199163.3
167483.25
125243.3
98843.25
Add: Depreciation
91000
91000
91000
91000
91000
Cash flows
276963.3
290163.3
258483.25
216243.3
189843.3
PV at 11.10%
249291.9
235079.2
188490.8308
141934
112156.6
926952.5
Initial cost
455000
Net present value of the project
471952.5
Years
cash flows
Pv of cash flows
1
276963.3
276963.3 / (1.111)^1
2
290163.3
29016.3 / (1.111)^2
3
258483.3
258483.3 / (1.111)^3
4
216243.3
216243.3 / (1.111)^4
5
189843.3
189843.3 / (1.111)^5
1
2
3
4
5
Total
sales
440000
465000
405000
325000
275000
Less:Variable costing
88000
93000
81000
65000
55000
Less:Fixed cost
60000
60000
60000
60000
60000
Interest5%
10237.5
10237.5
10237.5
10237.5
10237.5
Profit before Tax
281762.5
301762.5
253762.5
189762.5
149762.5
Marginal Tax 34%
95799.25
102599.3
86279.25
64519.25
50919.25
Net income
185963.3
199163.3
167483.25
125243.3
98843.25
Add: Depreciation
91000
91000
91000
91000
91000
Cash flows
276963.3
290163.3
258483.25
216243.3
189843.3
PV at 11.10%
249291.9
235079.2
188490.8308
141934
112156.6
926952.5
Initial cost
455000
Net present value of the project
471952.5
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