Concept explainers
Abandonment Decisions [LO5] Consider the following project of 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 $12 million that will be
Year | Market Value (millions) |
1 | $8.20 |
2 | 6.20 |
3 | 4.70 |
4 | .00 |
a. Assuming the company operates this project for four years, what is the
b. Now compute the project NPV 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?
a)
To find: The net present value
Introduction:
The variations between the present value of the cash outflows and the present value of the cash inflows are the net present value. In capital budgeting the net present value is utilized to analyze the profitability of a project or investment.
Answer to Problem 22QP
The net present value is $1,001,414.16.
Explanation of Solution
Given information:
Company HC considers the following project. The company is considering a 4 year project to produce clap-command garage door openers. The initial investment of the project is $12 million that has a straight line depreciation to zero over the project’s life. The initial investment in the net working capital that is essential to support the spare parts inventory is $900,000 and this cost is recoverable at the project’s end.
The company has a belief that it can generate a pretax revenue of $9.1 million and it will have a pretax operating cost of $3.7 million. The tax rate is 38% and the discount rate is 13%. The market value of the equipments over the life cycle of the project is as follows:
- The first year’s market value is $8.20 million
- The second year’s market value is $6.20 million
- The third year’s market value is $4.70 million
- The fourth market value is $0
Formula to calculate depreciation:
Computation of the depreciation:
It is given that investment is $12,000,000 and life of project is 4years. Depreciation is found using straight-line method.
Hence, annual depreciation is $3,000,000.
Computation of the cash flow for the year:
The depreciation is 3,000,000, initial investment is 12,000,000, investment in working capital is $900,000, sales are $9,100,000, tax rate is 38%, and discount rate is 13%.
The cash flow of the project is calculated with the bottom-up approach.
Year | 0 | 1 | 2 | 3 | 4 |
Sales | $9,100,000 | $9,100,000 | $9,100,000 | $9,100,000 | |
(-) Operating costs | 37,00,000 | 37,00,000 | 37,00,000 | 37,00,000 | |
(-) Depreciation | 30,00,000 | 30,00,000 | 30,00,000 | 30,00,000 | |
EBT | $2,400,000 | $2,400,000 | $2,400,000 | $2,400,000 | |
(-) Tax (38% of EBT) | 9,12,000 | 9,12,000 | 9,12,000 | 9,12,000 | |
Net income | $1,488,000 | $1,488,000 | $1,488,000 | $1,488,000 | |
+Depreciation | 30,00,000 | 30,00,000 | 30,00,000 | 30,00,000 | |
Operating CF | $4,488,000 | $4,488,000 | $4,488,000 | $4,488,000 | |
Change in NWC | –$900,000 | 0 | 0 | 0 | $900,000 |
Capital spending (Initial investment) | –$12,000,000 | 0 | 0 | 0 | 0 |
Total cash flow | –$12,900,000 | $4,488,000 | $4,488,000 | $4,488,000 | $5,388,000 |
Formula to calculate the net present value:
Note: The net present value is calculated by the above formula and this formula. PVIFA is the present value interest factor of annuity.
Computation of the net present value:
Note: The value of the PVIFA at 13% for 3 years is 2.3612.
Hence, the net present value is $1,001,572.
b)
To find: The net present value of the project if it is abandoned after a year, after two years, and after three years also determine the economic life of the project.
Introduction:
The cash value or the equivalent value that are associated with an asset is the abandonment value and it is also known as the liquidation value. The abandonment value is significant for a firm at the time of analyzing the profitability of a specific project or asset and taking decisions on whether it has to be maintained or abandoned.
Answer to Problem 22QP
The net present value of the project if it abandons within a year is - $606,194.6903, after 2 years is $87,266.0349, and after 3 years $1,130,212.4322.
Explanation of Solution
Given information:
Computation of the net present value of the project if it abandons within a year:
It is given that depreciation is 3,000,000, initial investment is 12,000,000, investment in working capital is $900,000, sales is $9,100,000, tax rate is 38%, and discount rate is 13%.
Year | 0 | 1 |
Sales | $9,100,000 | |
(-) Operating costs | 37,00,000 | |
(-) Depreciation | 30,00,000 | |
EBT | $2,400,000 | |
(-) Tax (38% of EBT) | 9,12,000 | |
Net income | $1,488,000 | |
+Depreciation | 30,00,000 | |
Operating CF | $4,488,000 | |
Change in NWC | –$900,000 | $900,000 |
Capital spending | –$12,000,000 | $8,504,000 |
(Initial investment) | ||
Total cash flow | –$12,900,000 | $13,892,000 |
Note: The capital spending that refers to the initial investment is the value of the equipment after tax (computed below).
Formula to calculate the book value of the equipment:
Computation of the book value of the equipment:
Hence, book value of equipment is $9,000,000.
Formula to calculate the tax of the equipment:
Computation of the tax of the equipment:
It is given that book value of equipment is $9,000,000, market value of equipment is $8,200,000, and tax rate is 38%.
Tax on equipment is book value minus market value multiplied with tax rate.
Hence, tax on equipment after one year is $304,000.
Formula to calculate the value of the equipment after tax:
Computation of the equipment value after tax:
It is given that market value of equipment is $8,200,000 and tax on equipment is $304,000.
Value of equipment after tax is market value of equipment plus tax on equipment.
Hence, value of equipment after tax is $8,504,000.
Formula to calculate the net present value:
Computation of the net present value:
It is given that cash inflow for the first year is $13,892,000, cash outflow is $12,900,000, cost of capital (r) is 13%, and time period (t) is 1year.
Hence, the net present value of the project is - $606,194.6903.
Computation of the net present value of the project if it abandons after 2 years:
It is given that depreciation is $3,000,000, initial investment is $12,000,000, investment in working capital is $900,000, sales is $9,100,000, tax rate is 38%, and discount rate is 13%.
Year | 0 | 1 | 2 |
Sales | $9,100,000 | $9,100,000 | |
(-) Operating costs | 37,00,000 | 37,00,000 | |
(-) Depreciation | 30,00,000 | 30,00,000 | |
EBT | $2,400,000 | $2,400,000 | |
(-) Tax (38% of EBT) | 9,12,000 | 9,12,000 | |
Net income | $1,488,000 | $1,488,000 | |
+Depreciation | 30,00,000 | 30,00,000 | |
Operating CF | $4,488,000 | $4,488,000 | |
Change in NWC | –$900,000 | 0 | $900,000 |
Capital spending (Initial investment) | –$12,000,000 | 0 | $6,124,000 |
Total cash flow | –$12,900,000 | $4,488,000 | $11,512,000 |
Note: The capital spending that refers to the initial investment is the value of the equipment after tax (computed below).
Computation of the equipment’s book value:
It is given that initial investment is $12,000,000, life is expected to be completed by the project is 2years, and total life of the project is 4years.
Hence, book value of equipment is $6,000,000.
Computation of the tax of the equipment:
It is given that book value of equipment is $6,000,000, market value of equipment is $6,200,000, and tax rate is 38%.
Tax on equipment is book value minus market value multiplied with tax rate.
Hence, value of equipment after two years is - $76,000.
Computation of the equipment’s value after tax:
It is given that market value of equipment is $6,200,000 and tax on equipment is $76,000.
Value of equipment after tax is market value of equipment plus tax on equipment
Hence, value of equipment after tax is $6,124,000.
Computation of the net present value:
It is given that cash inflow for the first year is $4,488,000, for second year is 11,512,000, cash outflow is $12,900,000, cost of capital (r) is 13%, and time period (t) is 1year.
Hence, value of equipment after tax is $87,266.0349.
Computation of the net present value if the abandonment of the project takes place after 3 years:
It is given that depreciation is 3,000,000, initial investment is 12,000,000, investment in working capital is $900,000, sales is $9,100,000, tax rate is 38%, and discount rate is 13%.
Year | 0 | 1 | 2 | 3 |
Sales | $9,100,000 | $9,100,000 | $9,100,000 | |
(-) Operating costs | 37,00,000 | 37,00,000 | 37,00,000 | |
(-) Depreciation | 30,00,000 | 30,00,000 | 30,00,000 | |
EBT | $2,400,000 | $2,400,000 | $2,400,000 | |
(-) Tax (38% of EBT) | 9,12,000 | 9,12,000 | 9,12,000 | |
Net income | $1,488,000 | $1,488,000 | $1,488,000 | |
+Depreciation | 30,00,000 | 30,00,000 | 30,00,000 | |
Operating CF | $4,488,000 | $4,488,000 | $4,488,000 | |
Change in NWC | –$900,000 | 0 | 0 | $900,000 |
Capital spending (Initial investment) | –$12,000,000 | 0 | 0 | $4,054,000 |
Total cash flow | –$12,900,000 | $4,488,000 | $4,488,000 | $9,442,000 |
Note: The capital spending that refers to the initial investment is the value of the equipment after tax (computed below).
Computation of the book value:
It is given that initial investment is $12,000,000, life completed by the project is 3years, and total life of the project is 4years.
Hence, book value of equipment is $3,000,000.
Computation of the equipment’s tax:
It is given that book value of equipment is $3,000,000, market value of equipment is $4,700,000, and tax rate is 38%.
Tax on equipment is book value minus market value multiplied with tax rate.
Hence, tax on equipment after three years is - $646,000.
Computation of the equipment after tax:
It is given that market value of equipment is $4,700,000 and tax on equipment is -$646,000.
Value of equipment after tax is market value of equipment plus tax on equipment
Hence, value of equipment after tax is $4,054,000.
Computation of the net present value:
It is given that cash inflow for first two years is $4,488,000 and for third year is $9,442,000, cash outflow is $12,900,000, cost of capital (r) is 13%, and period (t) is 1year. The “present value” interest factor annuity (PVIFAr,t) is 1.6681 with 13% interest for two years.
Hence, the net present value is $1,130,212.4322.
Want to see more full solutions like this?
Chapter 24 Solutions
FUND.CORP.FIN. ACCESS CODE CARD >I<
- A3 8av You are considering a new product launch. The project will cost $680,000, have a four-year life, and have no salvage value; depreciation is straight-line to zero. Sales are projected at 100 units per year, price per unit will be $19,000, variable cost per unit will be $14,000, and fixed costs will be $150,000 per year. The required return on the project is 15%, and the relevant tax rate is 35%. Ignore the half-year rule for accounting for depreciation. a. Calculate the following six numbers for this project. Round your answers to two decimal places. (v) Internal Rate of Return (IRR in %)arrow_forwardA3 8ai You are considering a new product launch. The project will cost $680,000, have a four-year life, and have no salvage value; depreciation is straight-line to zero. Sales are projected at 100 units per year, price per unit will be $19,000, variable cost per unit will be $14,000, and fixed costs will be $150,000 per year. The required return on the project is 15%, and the relevant tax rate is 35%. Ignore the half-year rule for accounting for depreciation. a. Calculate the following six numbers for this project. Round your answers to two decimal places. (i) NPVarrow_forwardQuestion 33 Brandt Enterprises is considering a new project that has a cost of $1,000,000, and the CFO set up the following simple decision tree to show its three most likely scenarios. The firm could arrange with its work force and suppliers to cease operations at the end of Year 1 should it choose to do so, but to obtain this abandonment option, it would have to make a payment to those parties. How much is the option to abandon worth to the firm? a. $64.08 b. $55.08 c. $67.29 d. $61.03 e. $57.98arrow_forward
- A3 8aiv You are considering a new product launch. The project will cost $680,000, have a four-year life, and have no salvage value; depreciation is straight-line to zero. Sales are projected at 100 units per year, price per unit will be $19,000, variable cost per unit will be $14,000, and fixed costs will be $150,000 per year. The required return on the project is 15%, and the relevant tax rate is 35%. Ignore the half-year rule for accounting for depreciation. a. Calculate the following six numbers for this project. Round your answers to two decimal places. (iv) Discounted payback period (in years)arrow_forward2 Net Present Value (NPV) Example 1 (Ross et al., 2023, pp. 299-300): We want to establish a new fertilizer business. The project costs $30,000 to launch. The project can generate cash revenues of $20,000 per year. The project will incur cash costs (including taxes) of $14,000 per year. The project will be terminated in 8 years and the project's assets can be sold for $2,000 at that time. A 15% discount rate is appropriate for this project. a. Should we undertake this project? b. If there are 1,000 shares of stock outstanding, what will be the effect on the price per share from taking the project?arrow_forwardA3 8avi You are considering a new product launch. The project will cost $680,000, have a four-year life, and have no salvage value; depreciation is straight-line to zero. Sales are projected at 100 units per year, price per unit will be $19,000, variable cost per unit will be $14,000, and fixed costs will be $150,000 per year. The required return on the project is 15%, and the relevant tax rate is 35%. Ignore the half-year rule for accounting for depreciation. a. Calculate the following six numbers for this project. Round your answers to two decimal places. (vi) Average Accounting Return (AAR in %) Hint: Net Income = {[(Price – variable cost)*Quantity Sold] – Fixed Costs – Depreciation} * (1 – Tax rate)arrow_forward
- E10.21 (LO3) (Government Grants) Rialto Group received a grant from the government of £100,000 to acquire £500,000 of delivery equipment on January 2, 2019. The delivery equipment has a useful life of 5 years. Rialto uses the straight-line method of depreciation. The delivery equipment has a zero residual value. Instructions A. If Rialto Group reports the grant as a reduction of the asset, answer the following questions. 1. What is the carrying amount of the delivery cquipment on the statement of financial position at December 31I, 2019? 2. What is the amount of depreciation expense related to the delivery equipment in 2020? 3. What is the amount of grant revenue reported in 2019 on the income statement? B. If Rialto Group reports the grant as deferred grant revenue, answer the following questions. 1. What is the balance in the deferred grant revenue account at December 31, 2019?…arrow_forwardE7.7 (LO 3, 4), AP Shruti Shrills is considering an expansion of one of its existing buildings to add more manufacturing space for its kid-friendly noisemakers. Several possible scenarios exist for future cash flows, as follows. 1. Construction costs of $500,000; steady sales and costs each year, netting to an annual operating cash inflow of $70,000; the expansion would have no salvage value at the end of its 10-year useful life (the building would be repurposed for a different product).2. Construction costs of $500,000; rising and then falling net cash flows each year for 10 years, as follows: $50,000 for the first 2 and last 2 years, $175,000 for years 3–5, and $100,000 for years 6–8.3. Construction costs of $700,000; no cash flows in year 1, $75,000 in years 2 and 3, $150,000 in year 4, $100,000 in years 5–8, and $50,000 in the last 2 years.Required 1. Calculate the simple payback period for all three scenarios.2. Assume that Shruti will only accept investments with a payback period…arrow_forwarduse excel/show all excel formulas answering the following LO3 20. Sensitivity Analysis We are evaluating a project that costs $1.68 million, has a six-year life, and has no salvage value. Assume that depreciation is straight-line to zero over the life of the project. Sales are projected at 90,000 units per year. Price per unit is $37.95, variable cost per unit is $23.20, and fixed costs are $815,000 per year. The tax rate is 21 percent, and we require a return of 11 percent on this project. a. Calculate the base-case cash flow and NPV. What is the sensitivity of NPV to changes in the sales figure? Explain what your answer tells you about a 500-unit decrease in projected sales. b. What is the sensitivity of OCF to changes in the variable cost figure? Explain what your answer tells you about a $1 decrease in estimated variable costs. LO3 21. Scenario Analysis In the previous problem, suppose the projections given for price, quantity, variable costs, and fixed costs are all accurate to…arrow_forward
- H5. St. Johns River Shipyards is considering the replacement of an 8-year-old riveting machine with a new one that will increase earnings before depreciation from $24,000 to $44,000 per year. The new machine will cost $82,500, and it will have an estimated life of 8 years and no salvage value. The new riveting machine is eligible for 100% bonus depreciation at the time of purchase. The applicable corporate tax rate is 25%, and the firm's WACC is 12%. The old machine has been fully depreciated and has no salvage value. What is the NPV of the project? Negative value, if any, should be indicated by a minus sign. Round your answer to the nearest cent.arrow_forwardCash Flows and NPV (LO2) We project unit sales for a new household-use laser-guided cockroach search and destroy system as follows Year Unit Sales 1 93,000 2 105,000 3 128,000 4 134,000 5 87, 000 The new system will be priced to sell at $380 each. The cockroach eradicator project will require $1, 800, 000 in net working capital to start, and total net working capital will rise to 15% of the change in sales. The variable cost per unit is $265, and total fixed costs are $1, 200, 000 per year. The equipment necessary to begin production will cost a total of $24 million. This equipment is mostly industrial machinery and thus qualifies for CCA at a rate of 20%. In five years, this equipment will actually be worth about 20% of its cost. The relevant tax rate is 35%, and the required retum is 18%. Based on these preliminary estimates, what is the NPV of the project?arrow_forward15) Although the Chen Company's milling machine is old, it is still in relatively good working order and would last for another 10 years. It is inefficient compared to modern standards, though, and so the company is considering replacing it. The new milling machine, at a cost of $120,000 delivered and installed, would also last for 10 years and would produce after-tax cash flows (labor savings and depreciation tax savings) of $20,000 per year. It would have zero salvage value at the end of its life. The project cost of capital is 12%, and its marginal tax rate is 25%. Should Chen buy the new machine? Do not round intermediate calculations. Round your answer to the nearest cent. Negative value, if any, should be indicated by a minus sign. NPV: $ Chen -Select-should shouldn't Item 2 purchase the new machine.arrow_forward