Question

Joe Biden Corp. is considering a project with an initial fixed asset cost of $1.5 million which will be depreciated straight-line to a zero book value over the 10-year life of the project. At the end of the project the equipment will be sold for an estimated $300,000. The project will not directly produce any sales but will reduce operating costs by $400,000 a year. The tax rate is 21 percent. The project will require $45,000 of inventory which will be recouped when the project ends. Should this project be implemented if the firm requires a 13 percent rate of return? Why or why not?

a. Yes, The NPV is $423,693.52
b. Yes; The NPV is $40,570.06
c. Yes; The NPV is $143,560.84
d. No; The NPV is −$74.814.56
e. No; The NPV is −$1,004,710.21

Answer 1

To determine if the project should be implemented, the NPV must be calculated by discounting the annual cash flow savings and the final year's after-tax salvage value plus the recovered working capital at the required rate of return and subtracting the initial investment. None of the provided NPV options match the result of the calculation, indicating a discrepancy or an error in the given options.

Step-by-step explanation:

To determine if Joe Biden Corp. should undertake the project, we need to calculate the Net Present Value (NPV) using the data given and compare it with the required rate of return. The initial fixed asset cost is $1.5 million, which is depreciated straight-line over 10 years, resulting in an annual depreciation expense of $150,000. The selling price of the equipment at the end of the project is $300,000. The tax savings from the operating cost reduction are calculated by multiplying the annual operating cost reduction of $400,000 by (1 - tax rate), which equals $316,000 (400,000 * (1 - 0.21)).

The cash flow from the sale of equipment at the end of the project is the after-tax salvage value. This is calculated by subtracting the taxes on the sale, if any. Taxes on sale are the tax rate times the difference between the salvage value and the book value (if the salvage value is higher). In this case, there is no book value at the end of the project; hence the entire salvage value is taxable, resulting in a tax of $63,000 (0.21 * 300,000). Hence the after-tax salvage value is $237,000 (300,000 - 63,000).

We also add back the non-depreciating working capital at the end of the project, which is $45,000. The cash flows for each year consist of the tax savings from the cost reduction, and the final year includes the after-tax salvage value plus recovered working capital. These cash flows are discounted at the required rate of return of 13% to find the NPV.

Calculating the NPV: The NPV formula is NPV = (Cash Flow / (1 + r)^t) - Initial Investment, where r is the discount rate and t is the time period. When calculated, we find that none of the provided NPV options match the calculated NPV. We need to discount each year's cash flow of $316,000 and the final year's cash flow, which includes the after-tax salvage value and the recovered working capital, at the required rate of return and subtract the initial investment to find the NPV.