Management of Group A Corporation is considering an expansion in the company’s product line that requires...

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Finance

Management of Group A Corporation is considering anexpansion in the company’s product line that requires the purchaseof an additional $200,000 in equipment with installation cost of$20,000 and removal expense of $5,000. The equipment andinstallation costs will be depreciated over five years usingstraight-line depreciation method. The expansion is expected toincrease earnings before depreciation and taxes asfollows:
Expected Worst Best
Year 1 $75,000 $50,000 $100,000
Year 2 $ 75,000 $60,000 $100,000
Year 3 $90,000 $75,000 $120,000
Year 4 $90,000 $75,000 $120,000
Year 5 $60,000 $45,000 $ 75,000
Group A Corporation’s income tax rate is 30 percent, andthe weighted average cost of capital is 10 percent. Because ofuncertainty in the market, the company’s financial analyst predictsthat the likelihood that the worst-case scenario happening is 20%;and the likelihood of the best-case scenario occurring is 30%.Based upon the net present value method of capital budgeting shouldmanagement undertake this project?

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3.9 Ratings (671 Votes)

NPV Present value of future inflows initial outflow Calculation of future inflows Expected increase in EBDT Year 1 Year 2 Year 3 Year 4 Year 5 Scenerios Probabiltiy EBDT P EBDT EBDT P EBDT EBDT P EBDT EBDT P EBDT EBDT P EBDT Expected 50 75000 37500 See Answer

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Management of Group A Corporation is considering anexpansion in the company’s product line that requires the purchaseof an additional $200,000 in equipment with installation cost of$20,000 and removal expense of $5,000. The equipment andinstallation costs will be depreciated over five years usingstraight-line depreciation method. The expansion is expected toincrease earnings before depreciation and taxes asfollows:Expected Worst BestYear 1 $75,000 $50,000 $100,000Year 2 $ 75,000 $60,000 $100,000Year 3 $90,000 $75,000 $120,000Year 4 $90,000 $75,000 $120,000Year 5 $60,000 $45,000 $ 75,000Group A Corporation’s income tax rate is 30 percent, andthe weighted average cost of capital is 10 percent. Because ofuncertainty in the market, the company’s financial analyst predictsthat the likelihood that the worst-case scenario happening is 20%;and the likelihood of the best-case scenario occurring is 30%.Based upon the net present value method of capital budgeting shouldmanagement undertake this project?