capital budgeting

| December 10, 2015

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

Consider the case of McFann Co.:

McFann Co. is considering an investment that will have the following sales, variable costs, and fixed operating costs:

YEAR 1           YEAR 2           YEAR 3       YEAR 4

Unit Sales                                                    $3,500              $4,000            $4,200          $4,250

Sales Price                                                    $38.50              $39.88            $40.15          $41.55

Variable Cost Per Unit                                   $22.34              $22.85            $23.67          $23.87

Fixed Operating Cost (except depreciation)  $37,000            $37,500          $38,120        $39,560

Accelerated Depreciation Rate                         33%                 45%                15%               7%

This project will require an investment of $10,000 in new equipment. The equipment will have no salvage value at the end of the project’s four-year life. McFann pays a constant tax rate of 40% and it has a weighted average of cost of capital (WACC) of 11%.

1. What would the project’s net present value (NPV) using accelerated depreciation?

2. What would the project’s net present value (NPV) using straight-line depreciation?

3. No other firm would take on this project if McFann turns it down. How much should McFann reduce the NPV of this project if it discovered that this project would reduce one of its division’s net after-tax cash flows by $300 for each year of the four-year project?

4. McFann spent $2,500 on a marketing study to estimate the number of units that it can sell each year. What should McFann to do take this information into acount:

a. Nothing, because the cost of the marketing study is a “sunk” cost.

b. Increase the amount of the initial investment by $2,500.

c. Increase the NPV of the project by $2,500.

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capital budgeting

Category: Finance

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