Question

Cochrane, Inc., is considering a new three-year expansion project that requires an initial fixed asset investment of $2,430,000. The fixed asset will be depreciated straight-line to zero over its three-year tax life, after which time it will be worthless. The project is estimated to generate $2,260,000 in annual sales, with costs of $1,250,000. Assume the tax rate is 40 percent and the required return on the project is 8 percent.

Required:
What is the project's NPV?

Answer 1

To calculate the NPV of Cochrane, Inc.'s new project, we must first calculate the annual depreciation, then the project's operating cash flow, discount the cash flows to present value, and finally subtract the initial investment from the sum of these discounted cash flows.

Step-by-step explanation:

The student is asking to calculate the Net Present Value (NPV) of a new project for Cochrane, Inc. To find the NPV, we need to estimate the project’s cash flows and then discount them back to the present value at the required return rate.

Here are the steps to calculate the NPV:

1. Calculate the annual depreciation of the fixed asset, which is $2,430,000 ÷ 3 = $810,000.
2. Determine the project’s operating cash flow (OCF). The OCF can be calculated using the formula: OCF = (Sales - Costs) × (1-Tax Rate) + Depreciation. Substituting the values: OCF = ($2,260,000 - $1,250,000) × (1-0.40) + $810,000.
3. Discount the OCFs back to the present value using the required return of 8%.
4. Sum the present values of the OCFs for the three years and subtract the initial investment to obtain the NPV.

The exact NPV calculation would require the use of a financial calculator or software to find the present value of the cash flows.