The Pierpont Company is thinking of building a plant to make trumpets. The plant

Question

The Pierpont Company is thinking of building a plant to make trumpets. The plant and equipment will cost $1 million. It will last for five years and will have no salvage value at the end of that time. The costs of running the plant are expected to be $100,000 per year. The revenues from selling the trumpets are expected to be $375,000 per year. All cash flows occur at the end of the year. The firm uses straight line depreciation. Its corporate tax rate is 35 percent and the opportunity cost of capital for this project is 10 percent. The projected income statement for the project is as follows. Revenues $375,000 Operating Expenses -$100,000 Net Operating Income $275,000 Depreciation -$200,000 Taxable Income $75,000 Taxes -$26,250 Net Income $48,750 Should the firm build the plant?

Explanation / Answer

Alternative 1:

Revenues $375,000
Operating Expenses -$100,000
Net Operating Income $275,000
Depreciation -$200,000
Taxable Income $75,000
Taxes -$26,250
Net Income $48,750
Add back: Depreciation $200,000
Cash flow years 1-5 $248,750

NPV Calculation:
= -1M + 248,750 * AF(5yrs,10%) = -1M + 248,750 * 3.791 = -$56,989
The negative NPV implies that the firm should not build the plant.

Alternative 2:

After tax operating income = $(375,000-100,000)*.65 = $178,750
Depreciation tax shield = $200,000*0.35 =$70,000
Cost of the plant = $-1M

NPV = -1M + (178,750+70,000) * AF(5yrs,10%)
          = -1M + 248,750 * 3.791 = -$56,989

Therefore as per any of the above alternative, the purchase is not advisable.

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