3. Analysis of an expansion project Companies invest in expansion projects with
ID: 2795857 • Letter: 3
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3. Analysis of an expansion project Companies invest in expansion projects with the expectation of increasing the eamings of its business. Consider the case of McFann Co.: McFann 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 4,2004,100 4,300 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 7% Unit sales Sales price Variable cost per unit Accelerated depreciation rate 3396 45% 1596 This project will require an investment of $15,000 in new equipment. The equipment will have no salvage value at the end 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 Determine what the project's net present value (NPV) would be when using accelerated depreciation. of the project's four-year life . McFann paysa O $56,964 O $59,441 O $49,534 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 project. No other firm would take on this project if McFann turns it down. How much should McFann 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 $700 for each year of the four-year project? O $1,629 O $1,303 O $2,389 O $2,172 McFann spent $2,500 on a marketing study to estimate the number of units that it can sell each year. What should McFann do to take this information into account? O Increase the amount of the initial investment by $2,500 O Increase the NPV of the project $2,500. O The company does not need to do anything with the cost of the marketing study because the marketing study is a sunk cost.Explanation / Answer
Firstly, note that depreciation is a non cash expense. This means irrespective of which depreciation method you use, the NPV would be same if you don't consider tax implications. But, with tax being a factor the choice of depreciation method will effect the depreciation shield and thereby the NPV value.
Depreciation value under straight line depreciation:
Value of equipment = $15,000; Time = 4 years; Salvage Value = 0
Depreciation value = (15,000 - 0) / 4 = $3,750
Depreciation value under accelerated depreciation:
Year 1: Depreciation = (0.33) (15,000) = 4,950
Year 2: Depreciation = (0.45) (15000) = 6,750
Year 3: Depreciation = (0.15) (15000) = 2,250
Year 3: Depreciation = (0.07) (15000) = 1,050
a. Calculation of NPV under accelerated depreciaiton method
Cash Flow for each of the years to be considered for NPV calculation = Net Income + Depreciation
WACC = 11%; Initial cash flow = $15,000
NPV = -15000 + [21908.40 / (1.11)] + [18411 / (1.11)2] + [17794.20 / (1.11)3] + [25569.60 / (1.11)4]
= -15000 + 19737.30 + 14942.78 + 13010.96 + 16843.49
= 49,534.53
Therefore, using accelerated depreciation, NPV = $49,534
b. Calculation of NPV using Straight line depreciation
Cash Flow for each of the years to be considered for NPV calculation = Net Income + Depreciation
WACC = 11%; Initial cash flow = $15,000
NPV = -15000 + [21428.40 / (1.11)] + [17211 / (1.11)2] + [18394.20 / (1.11)3] + [26649.60 / (1.11)4]
= -15000 + 19304.86 + 13968.83 + 13449.68 + 17554.92
= 49,278.29
Therefore, using accelerated depreciation, NPV = $49,278
Using accelerated depreciation method will result in highest NPV for the project.
Accelerated Depreciation % 33% 45% 15% 7%Related Questions
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