ELC Electrical Services is considering the construction of a plant to manufactur
ID: 2721791 • Letter: E
Question
ELC Electrical Services is considering the construction of a plant to manufacture a new energy saving device for small offices. The company recently commissioned a $100,000, two-year study to assess the market demand for the proposed product. It estimated that 30,000 units of its new product could be sold annually over the next 10 years at a price of $10,000 each. Subcontractors would install each device at a cost of $6,200 per installation.
The project involves an initial outlay of $60 million to build production facilities and $4 million to purchase land. The $60 million facility will be depreciated using the prime cost method over the project’s life (fully depreciated at the end of the project). Fixed costs of $12 million per annum will be incurred. The facilities, including the land, will be sold for an estimated value of $15 million at the end of the project. The land value is assumed to stay constant throughout the lifespan of the project.
The company is an ongoing profitable business and pays taxes at a 30% rate in the year of income. It uses a 15% per year discount rate on the new project. Using the NPV approach, determine whether the project should be undertaken (use the relevant tax rate in your analysis).
Explanation / Answer
Initial Outflow = Cost of Production facility + Cost of land + Cost of market study
=> $60,000,000 + $4,000,000 + $100,000 = $64,100,000
Depreciation every year = $60,000,000/10 = $6,000,000
After-tax salvage value = $15,000,000 – [($15,000,000 - $4,000,000) x 0.30] = $11,700,000
(Note: We will subtract the value of land while calculating the tax on salvage value as the land value hasn’t appreciated in project’s life.)
Sales per year = $10,000 x 30,000 = $300,000,000
Variable cost per year = $6,200 x 30,000 = $186,000,000
Fixed cost per year = $12,000,000
Cash Inflow:
Year
Through Year 1 to 9
Sales
$300,000,000.00
Less: Variable Cost
$186,000,000.00
Less: Fixed Cost
$12,000,000.00
Less: Depreciation
$6,000,000.00
EBT
$96,000,000.00
Less: Tax @ 30%
$28,800,000.00
Net Income
$67,200,000.00
Add: Depreciation
$6,000,000.00
Add: After-tax Salvage Value of Machine
$0.00
Net Operating Cash flow
$73,200,000.00
We also need to add Present Value of after-tax salvage while calculating NPV.
PV of after-tax salvage value = $11,700,000 / (1.15)10 = $2,892,061
NPV = R x {[1 – (1+i)-n] / i} – Initial Investment + PV of after-tax salvage value
R is the net cash inflow expected to be received in each period;
i is the required rate of return per period;
n are the number of periods during which the project is expected to operate and generate cash inflows
NPV = $73,200,000 x {[1 – (1+0.15)-10] / 0.15} – $64,100,000 + $2,892,061 = $306,165,924.41
As the NPV is positive, the project must be selected.
Year
Through Year 1 to 9
Sales
$300,000,000.00
Less: Variable Cost
$186,000,000.00
Less: Fixed Cost
$12,000,000.00
Less: Depreciation
$6,000,000.00
EBT
$96,000,000.00
Less: Tax @ 30%
$28,800,000.00
Net Income
$67,200,000.00
Add: Depreciation
$6,000,000.00
Add: After-tax Salvage Value of Machine
$0.00
Net Operating Cash flow
$73,200,000.00
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