3. Analysis of an expansion project
Companies invest in expansion projects with the expectation ofincreasing the earnings of its business.
Consider the case of Yeatman Co.:
Yeatman Co. is considering an investment that will have thefollowing sales, variable costs, and fixed operating costs:
| Year 1 | Year 2 | Year 3 | Year 4 |
|---|
| Unit sales | 3,000 | 3,250 | 3,300 | 3,400 |
| Sales price | $17.25 | $17.33 | $17.45 | $18.24 |
| Variable cost per unit | $8.88 | $8.92 | $9.03 | $9.06 |
| Fixed operating costs | $12,500 | $13,000 | $13,220 | $13,250 |
This project will require an investment of $15,000 in newequipment. Under the new tax law, the equipment is eligible for100% bonus deprecation at t = 0, so it will be fully depreciated atthe time of purchase. The equipment will have no salvage value atthe end of the project’s four-year life. Yeatman pays a constanttax rate of 25%, and it has a weighted average cost of capital(WACC) of 11%. Determine what the project’s net present value (NPV)would be under the new tax law.
Determine what the project’s net present value (NPV) would beunder the new tax law.
$22,858
$27,430
$26,287
$18,286
Now determine what the project’s NPV would be when usingstraight-line depreciation.
Using the depreciation method willresult in the highest NPV for the project.
No other firm would take on this project if Yeatman turns itdown. How much should Yeatman reduce the NPV of this project if itdiscovered that this project would reduce one of its division’s netafter-tax cash flows by $400 for each year of the four-yearproject?
$1,365
$1,055
$1,241
$745
The project will require an initial investment of $15,000, butthe project will also be using a company-owned truck that is notcurrently being used. This truck could be sold for $18,000, aftertaxes, if the project is rejected. What should Yeatman do to takethis information into account?
Increase the amount of the initial investment by $18,000.
Increase the NPV of the project by $18,000.
The company does not need to do anything with the value of thetruck because the truck is a sunk cost.
