Sanders Enterprises, Inc., has been considering the purchase of a new manufactur
ID: 2774012 • Letter: S
Question
Sanders Enterprises, Inc., has been considering the purchase of a new manufacturing facility for $280,000. The facility is to be fully depreciated on a straight-line basis over seven years. It is expected to have no resale value after the seven years. Operating revenues from the facility are expected to be $115,000, in nominal terms, at the end of the first year. The revenues are expected to increase at the inflation rate of 2 percent. Production costs at the end of the first year will be $40,000, in nominal terms, and they are expected to increase at 3 percent per year. The real discount rate is 5 percent. The corporate tax rate is 40 percent. Sanders has other ongoing profitable operations.
Explanation / Answer
Annual depreciation = (cost of asset – salvage value)/ life of the project
=( 280,000 -0)/ 7
= 40,000
Nominal discount rate = real rate + inflation rate
= 5%+2%
= 7%
Revenue is increasing 2% per annuam and production cost is increasing 3% per annuam.
year
1
2
3
4
5
6
7
Operating revenue
115000
117300
119646
122038.92
124479.7
126969.3
129508.68
(-)production expenses
-40000
-41200
-42436
-43709.08
-45020.35
-46371
-47762.09
(-) Depreciation
-40000
-40000
-40000
-40000
-40000
-40000
-40000
Income before taxes
35000
36100
37210
38329.84
39459.346
40598.33
41746.586
(-) taxes 40%
-14000
-14440
-14884
-15331.936
-15783.74
-16239.3
-16698.63
Net income
21000
21660
22326
22997.904
23675.608
24359
25047.952
(+) Depreciation
40000
40000
40000
40000
40000
40000
40000
Cash flow
61000
61660
62326
62997.904
63675.608
64359
65047.952
PV factor 7%
0.9346
0.8734
0.8163
0.7629
0.7130
0.6663
0.6227
PV
57009.35
53856.23
50876.58
48060.80
45399.83
42885.12
40508.60
Total PV of inflows
338596.5
NPV = PV of inflows – initial outflow
=338,596.50 – 280,000
=58,596.50
Since the NPV is positive, it is worthwhile to take the project.
year
1
2
3
4
5
6
7
Operating revenue
115000
117300
119646
122038.92
124479.7
126969.3
129508.68
(-)production expenses
-40000
-41200
-42436
-43709.08
-45020.35
-46371
-47762.09
(-) Depreciation
-40000
-40000
-40000
-40000
-40000
-40000
-40000
Income before taxes
35000
36100
37210
38329.84
39459.346
40598.33
41746.586
(-) taxes 40%
-14000
-14440
-14884
-15331.936
-15783.74
-16239.3
-16698.63
Net income
21000
21660
22326
22997.904
23675.608
24359
25047.952
(+) Depreciation
40000
40000
40000
40000
40000
40000
40000
Cash flow
61000
61660
62326
62997.904
63675.608
64359
65047.952
PV factor 7%
0.9346
0.8734
0.8163
0.7629
0.7130
0.6663
0.6227
PV
57009.35
53856.23
50876.58
48060.80
45399.83
42885.12
40508.60
Total PV of inflows
338596.5
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