Question #1 A firm believes it can generate an additional $1,700,000 per year in
ID: 2420620 • Letter: Q
Question
Question #1
A firm believes it can generate an additional $1,700,000 per year in revenues for the next 5 years (years 1-5) and $2,100,000 for the next 5 years after that (years 6-10) if it replaces existing equipment that is no longer usable with new equipment that costs $3,500,000. The existing equipment has a book value of $50,000 and a market value of $10,000. The firm expects to be able to sell the new equipment when it is finished using it (after 10 years) for $40,000. Variable costs are expected to be 44% of revenue for the entire 10 years. The additional sales will require an initial investment in net working capital of $220,000, which is expected to be recovered at the end of the project (after 10 years). Assume the firm uses straight line depreciation, its marginal tax rate is 35%, and the discount rate for the project is 11%.
a) How much value will this new equipment create for the firm?
b) At what discount rate will this project break even?
c) Should the firm purchase the new equipment? Be sure to justify your recommendation.
d) How would your analysis change if the firm believes the project is more risky than initially expected? Be specific.
Explanation / Answer
Year Initial Investment in Equipment Sale value old equipment Initial investment in NWC Incremental revenue Variable cost Depreciation Taxable income Post Tax Income considering 35% Tax Add back Depreciation Equipment Sale value NWC return Discount Factor@11% Tax benefit of loss on old euipment PV of Cash Flows Year 0 (3,500,000) 10,000 (220,000) 1 14,000 (3,696,000) Year 1 1,700,000 (748,000) (31,000) 921,000 598,650 31,000 0.901 567,252 Year 2 1,700,000 (748,000) (31,000) 921,000 598,650 31,000 0.812 511,038 Year 3 1,700,000 (748,000) (31,000) 921,000 598,650 31,000 0.731 460,395 Year 4 1,700,000 (748,000) (31,000) 921,000 598,650 31,000 0.659 414,770 Year 5 1,700,000 (748,000) (31,000) 921,000 598,650 31,000 0.593 373,667 Year 6 2,100,000 (924,000) (31,000) 1,145,000 744,250 31,000 0.535 414,480 Year 7 2,100,000 (924,000) (31,000) 1,145,000 744,250 31,000 0.482 373,406 Year 8 2,100,000 (924,000) (31,000) 1,145,000 744,250 31,000 0.434 336,402 Year 9 2,100,000 (924,000) (31,000) 1,145,000 744,250 31,000 0.391 303,064 Year 10 2,100,000 (924,000) (31,000) 1,145,000 744,250 31,000 40,000 220,000 0.352 102,486 NPV = 160,959 1 Value created by equipment =$ 160,959 2 IRR calculation Year Initial Investment in Equipment Sale value old equipment Initial investment in NWC Incremental revenue Variable cost Depreciation Taxable income Post Tax Income considering 35% Tax Add back Depreciation Equipment Sale value NWC return Discount Factor@12.024% Tax benefit of loss on old euipment PV of Cash Flows Year 0 (3,500,000) 10,000 (220,000) 1 14,000 (3,696,000) Year 1 1,700,000 (748,000) (31,000) 921,000 598,650 31,000 0.893 562,067 Year 2 1,700,000 (748,000) (31,000) 921,000 598,650 31,000 0.797 501,738 Year 3 1,700,000 (748,000) (31,000) 921,000 598,650 31,000 0.711 447,884 Year 4 1,700,000 (748,000) (31,000) 921,000 598,650 31,000 0.635 399,811 Year 5 1,700,000 (748,000) (31,000) 921,000 598,650 31,000 0.567 356,898 Year 6 2,100,000 (924,000) (31,000) 1,145,000 744,250 31,000 0.506 392,261 Year 7 2,100,000 (924,000) (31,000) 1,145,000 744,250 31,000 0.452 350,158 Year 8 2,100,000 (924,000) (31,000) 1,145,000 744,250 31,000 0.403 312,574 Year 9 2,100,000 (924,000) (31,000) 1,145,000 744,250 31,000 0.360 279,024 Year 10 2,100,000 (924,000) (31,000) 1,145,000 744,250 31,000 40,000 220,000 0.321 93,494 NPV = (90) IRR of the project is 12.024 % c As the project is generating some positive NPV , it can be accepted and equipment can be purchased. d As the break even discount rate is 12.02% , if the project turns out riskier than initial estimate , the NPV would become negative. So in that case better bot to purchase the equipment