Consider the following project for hand clapper, inc. The company is considering
ID: 2675047 • Letter: C
Question
Consider the following project for hand clapper, inc. The company is considering a four-year project to manufacture clap-command garage door openers. This project requires an initial investment of $10 million that will be depreciated straight-line to zero over the project's life. An initial investment in net working capital of $1.3 million is required to support spare parts inventory; this cost is fully recoverable whenever the project ends. The company believes it can generate $7.35 million in pretax revenues with $2.4 million in total pretax operating costs. The tax rate is 38 percent, and the discount rate is 16 percent. The market value of the equipment over the life of the project is as follows:Year Market value($ milllions)
1 $6.8
2 6.2
3 3.8
4 0.0
a) Assuming Hand Clapper operates this project for four years, what is the NPV?
b)Now compute the project NPVs assuming the project is abandoned after only one year, after two years, and after three years. What economic life for this project maximizes its value to the firm? What does this problem tell you about not considering abandonment possibilities when evaluating projects?
Explanation / Answer
Yearly BTCF = 7,350,000-2,400,000 = 4,950,000
Yearly depreciation = (10,000,000)/4 = 2,500,000
Taxable income = 4,950,000 - 2,500,000 = 2,450,000
Tax = 2,450,000 * 38% = 931,000
Yearly ATCF = 4,950,000 - 931,000 = 4,019,000
Investment = 11,000,000 + 1,300,000 = 11,300,000
Market values:
Year 1 = 6,800,000 before taxes --> 6,800,000 - (6,800,000*38%) = 4,216,000 after taxes
Year 2 = 6,200,000 before taxes --> 6,200,000 - (6,200,000*38%) = 3,844,000 after taxes
Year 3 = 3,800,000 before taxes --> 3,800,000 - (3,800,000*38%) = 2,356,000 after taxes
Year 4 = 0
(a) NPV = -11,300,000 + 4,019,000 (P/F,i=16%,N=1) + 4,019,000 (P/F,i=16%,N=2) + 4,019,000 (P/F,i=16%,N=3) + 4,019,000 (P/F,i=16%,N=4)
NPV = -11,300,000 + 4,019,000 (1+16%)-1 + 4,019,000 (1+16%)-2 + 4,019,000 (1+16%)-3 + 4,019,000 (1+16%)-4 = -54,112.01
(b) After 1 year: NPV = -11,300,000 + [4,019,000 + 4,216,000](1+16%)-1= -4,200,862.07
After 2 years: NPV = -11,300,000 + 4,019,000 (1+16%)-1 + [4,019,000 + 3,844,000](1+16%)-2 = -1,991,854.93
After 3 years: NPV = -11,300,000 + 4,019,000 (1+16%)-1 + 4,019,000 (1+16%)-2 + [4,019,000 + 2,356,000](1+16%)-3 = -764,380.46
The economic life that maximizes the project's value to the firm is 4 years. This problem showed us that if we don't consider abandonment possibilities when evaluating projects, we may end up losing a lot of money.