Companies invest in expansion projects with the expectation of increasing the earnings of its business. Consider the...

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Finance

Companies invest in expansion projects with the expectation ofincreasing the earnings of its business.
Consider the case of McFann Co.:
McFann 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 4,200 4,100 4,300 4,400
Sales price $29.82 $30.00 $30.31 $33.19
Variable cost per unit $12.15 $13.45 $14.02 $14.55
Fixed operating costs except depreciation $41,000 $41,670 $41,890 $40,100
Accelerated depreciation rate 33% 45% 15% 7%
This project will require an investment of $15,000 in newequipment. The equipment will have no salvage value at the end ofthe project’s four-year life. McFann pays a constant tax rate of40%, and it has a weighted average cost of capital (WACC) of 11%.Determine what the project’s net present value (NPV) would be whenusing accelerated depreciation.
Determine what the project’s net present value (NPV) would bewhen using accelerated depreciation.
$56,964
$49,534
$44,581
$59,441
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 McFann turns itdown. How much should McFann reduce the NPV of this project if itdiscovered that this project would reduce one of its division’s netafter-tax cash flows by $500 for each year of the four-yearproject?
$1,163
$1,551
$1,706
$1,318
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 McFann do to takethis information into account?
Increase the amount of the initial investment by $18,000.
The company does not need to do anything with the value of thetruck because the truck is a sunk cost.
Increase the NPV of the project by $18,000.

	Year 1	Year 2	Year 3	Year 4
Unit sales	4,200	4,100	4,300	4,400
Sales price	$29.82	$30.00	$30.31	$33.19
Variable cost per unit	$12.15	$13.45	$14.02	$14.55
Fixed operating costs except depreciation	$41,000	$41,670	$41,890	$40,100
Accelerated depreciation rate	33%	45%	15%	7%

Answer & Explanation Solved by verified expert

3.7 Ratings (307 Votes)

NPV using Accelerated Depreciation Year 1 Year 2 Year 3 Year 4 Sales Price per unit 2982 3000 3031 3319 Variable Cost per unit 1215 1345 1402 1455 Contribution per unit 1767 1655 1629 1864 Number of units sold 4200 4100 4300 4400 Contribution Margin 74214 67855 70047 82016 Fixed Cost 41000 41670 41890 40100 Accelerated Depreciation Expenses Initial Investment x Accelerated Depreciation Rate 4950 6750 2250 1050 Earnings Before Tax 28264 19435 25907 40866 Tax at 40 11306 7774 10363 16346 Earnings After Tax 16958 11661 15544 24520 Add Depreciation Expenses 4950 6750 2250 1050 Annual Cash Inflow 21908 18411 17794 See Answer

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Transcribed Image Text

Companies invest in expansion projects with the expectation ofincreasing the earnings of its business.Consider the case of McFann Co.:McFann Co. is considering an investment that will have thefollowing sales, variable costs, and fixed operating costs:Year 1Year 2Year 3Year 4Unit sales4,2004,1004,3004,400Sales price$29.82$30.00$30.31$33.19Variable cost per unit$12.15$13.45$14.02$14.55Fixed operating costs except depreciation$41,000$41,670$41,890$40,100Accelerated depreciation rate33%45%15%7%This project will require an investment of $15,000 in newequipment. The equipment will have no salvage value at the end ofthe project’s four-year life. McFann pays a constant tax rate of40%, and it has a weighted average cost of capital (WACC) of 11%.Determine what the project’s net present value (NPV) would be whenusing accelerated depreciation.Determine what the project’s net present value (NPV) would bewhen using accelerated depreciation.$56,964$49,534$44,581$59,441Now 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 McFann turns itdown. How much should McFann reduce the NPV of this project if itdiscovered that this project would reduce one of its division’s netafter-tax cash flows by $500 for each year of the four-yearproject?$1,163$1,551$1,706$1,318The 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 McFann do to takethis information into account?Increase the amount of the initial investment by $18,000.The company does not need to do anything with the value of thetruck because the truck is a sunk cost.Increase the NPV of the project by $18,000.